Large Cap Industrials Working, Yield Curve Lags

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Large Cap Industrials Working, Yield Curve Lags

Two topics in “Data” today:

#1: We’ve been recommending US large cap Industrials for a few months now, so let’s check in on how they’re doing and assess what might be left in the tank. To do that we will take a longer-term view at how this group fares across cycles.

Here is a chart which shows Industrials’ out- and under-performance versus the S&P 500 over a 100-trading-day window back to 1999.

We see 2 actionable observations in this data, one macro and one micro:

  • Industrials’ recent outperformance (mid-May to today) of 12.9 points over the S&P 500 is historically quite remarkable. You have to go back to 2009 – 2010 (the middle of the chart) to find the last time this sector beat the S&P 500 by more than 10 points over a 100-day window. The only other time the group did this well (ex a sudden rotation at the end of dot com era) was in 2004.

    Takeaway: the outperformance here is a ringing endorsement on the part of equity markets in a brighter economic future for the US. History says that when the Industrials beat the S&P by 10 points or more, it is definitely the start of a new cycle.
  • At the same time, this group is pretty twitchy and needs a solid cyclical story to hold its outperformance. That chart shows lots of instances when Industrials lagged the broader US equity market, such as during mid-cycle slowdowns in 2005, 2006, 2011, 2012, and 2014.

Takeaway: we think there’s still money to be made in Industrials because this is a generally high fixed cost group (Union Pacific, UPS, Honeywell and 3M are the top 4 names and 20% of the sector) and a global economic recovery is just starting. This should provide the sort of earnings leverage that powers higher stock prices. Lastly, even if this group is too cyclical for your risk appetite, you can take some solace in the optimistic signal it is sending just now.

#2: There’s been a lot of attention lately on the increase in US 10-year Treasury yields, or at least more than we’d have thought likely given we’re talking about a move from August’s 0.52% level to the current 0.78%.

This got us to thinking about a topic that was all the rage last year but has fallen off most people’s radar screens in 2020: the difference between 3-month Treasury note yields and those of 10-year notes. The former is essentially set by Fed policy, the latter is somewhat more market based although the Fed certainly has its thumb on the scale due to its asset purchase program.

We know where short rates are – basically zero, with a Fed guaranty to remain there – so how far can 10-year yields climb? Here is the difference between 3-months and 10-years back to 1982:

The average across this timeframe is 1.75 points, so if 10-years were to trade in line with historical norms we might expect to see their yields rise to 1.85% since 3-month yields are 0.1%. Moreover, even a cursory examination of the chart shows that early in an economic cycle the 3M – 10-year spread can often be +3.0 points (1982, 1991, 2002 and 2009, for example). At present we’re at just 0.71 points, however, thanks to a range of factors including Fed policy, continued investor risk aversion, and high global savings rates.

Takeaway: higher 10-year Treasury yields just now would be entirely consistent with increasing market confidence in a US/global economic recovery. This is very much the same story as the prior point about Industrials, except in this case the bond market has lagged equity sector performance. Long-term yields are just starting to move, and that’s a macro positive for risk assets.