Stocks Look Beyond GDP Barnburner To Price Slower Growth

We’ve entered “a new phase of the rising rate saga.”

That’s according to Goldman’s David Kostin.

Well, actually, it’s according to “sharp underperformance” from cyclicals, which Kostin said is a sign that tighter financial conditions brought on by higher long-end yields and, relatedly, the term premium repricing since late-July, are weighing on market participants’ forward-looking growth assessments.

Utilities have outperformed in October “despite potential headwinds from high leverage,” Kostin observed, in the course of flagging ongoing troubles for small-caps and stocks with a high percentage of floating rate debt.

The figure on the right above is familiar. Note the very recent deterioration in cyclicals versus defensives and the accumulated, increasingly severe underperformance for small-caps (whose maturity wall is much steeper) and companies with exposure to rising rates.

The evolution of the market narrative as reflected in relative performance since May isn’t encouraging. “From May through July, rising bond yields were driven primarily by an improving growth outlook, lifting the broad market and supporting the outperformance of cyclical stocks,” Kostin wrote, on the way to briefly recapping what happened next. To wit:

As investor fears of imminent recession receded, improving economic growth expectations more than offset the discount rate pressure of a 60bps increase in the 10-year Treasury yield. The increase in rates between August and mid-October had a more negative impact on stocks because it occurred alongside stable growth expectations. The market’s pricing of economic growth peaked in late July, and the subsequent 100bps rise in the 10-year yield was spurred by expectations of “higher for longer” interest rate policy and shifting supply/demand dynamics in the Treasury market. Without an offsetting tailwind from growth, rising yields broadly compressed equity valuations and particularly weighed on stocks with weak balance sheets. Long-duration stocks also generally lagged, although the strong balance sheets of many Nasdaq 100 firms helped offset their vulnerability to rising discount rates. The combination of headwinds caused the Russell 2000 to lag the equal-weight S&P 500 by 360bps.

Now, Goldman’s US equities team cautioned, we’ve moved into a regime where investors are inclined to pull forward the expected eventual impact of recent FCI tightening on the economy. That, Kostin suggested, is showing up in sector, factor and style performance.

The good news is that if growth does roll over, it’ll help stabilize the unruly long-end of the US Treasury curve. That, in turn, could be a near-term boon to equities which are exhibiting clear signs of rate fatigue, as detailed extensively in “Scary Bonds.”

Over the medium-term, though, the fate of any “bad news is good news” dynamic hinges on how bad the bad news gets. As Kostin put it, “While interest rates matter for equity valuations, the long-term trajectory of stock returns is determined by earnings growth, so ‘bad news is good news’ cannot last for long.”

The irony, of course, is that the US economy just posted its best quarterly growth outcome in nearly two years. The advance read on Q3 GDP was a scorching-hot, consumption-fueled barnburner. Goldman’s economics team revised up their Q4 growth projection to 1.6% from 0.7%.