U.S. Treasuries No Longer the Hedge They Once Were, Investors are Reacting

 

  • Bloomberg – With Rates on the Rise, Bond Proxy Stocks Turn Into Problem Children
    ETFs tracking dividend payers see biggest outflow since 2016
    In the years of rock-bottom interest rates, investors piled into a class of stock coveted for its consistent payouts. Now, as the Federal Reserve looks certain to raise rates at least three times this year, the group is trotted out as Exhibit A for why the nine-year bull market might be in danger. Known as bond proxies, they’re the companies that peddle soap, diapers and ready-to-eat food. While they lack the heady price returns notched by high-flying tech and bank shares, they’ve been stalwart in the ability to return cash to investors. Consumer staples, phone and utility companies have the highest dividend yields, a measure of a stock’s price relative to its payout.

Summary

The newly forming relationship of U.S. equity returns moving in opposition to U.S. Treasury yields is wreaking havoc on asset and sector allocations. Inflation fears are infiltrating many investment decisions in ways not seen since prior to the Dot-com bust (2000). Investors are no longer able to confidently hedge equity exposure using long-end U.S. Treasuries, causing many to lower risk exposure.

Comment

The chart below shows monthly flows for U.S. high dividend, emerging market debt, and short-term government/corporate ETFs types. Money is pouring out of high dividend and emerging market debt ETFs at a pace not seen post-crisis. Conversely, consistent inflows are being seen in short-term fixed income ETFs.

Shifting investor allocations are more a result of changing correlations and hedging concerns than U.S. Treasury yields simply rising above dividend yields offered by equities.

 

 

The chart below shows three-month changes from 2000 to current in U.S. 5-year note yields (x-axis) versus the relative performance the S&P Dividend Aristocrats Index to the S&P 500 (y-axis). We highlight the post-crisis period in red, which has been heavily dominated by rising yields resulting in underperformance by high dividend stocks. 

 

 

 

But, the sensitivity of high dividend equities to U.S. Treasury yields was very muted from 1990 to 1999 (shown below). The periods prior to 2000 were filled with much higher inflation fears, making the relationship between equities and U.S. Treasuries much less reliable. Hedging equities and/or higher dividend equities using U.S. Treasuries would not be as advantageous and potentially lead to higher risk and potential losses. The traditional 60/40 portfolios are under attack.

 

 

The rolling one-year correlation between the relative performance of high dividend stocks and U.S. 10-year note returns has been tumbling since early 2017. Investors are reacting to an ending era of higher deflation (i.e. not inflation) fears.

 

 

Additionally, investors are shifting assets between equity sectors based on the difficulty to hedge risks with safe assets. The chart below shows the rolling one-year correlation between relative equity sector performance to the S&P 500 and U.S. 10-year note returns.

Sectors like utilities, consumer staples, telecom, and real estate are all seeing correlations to U.S. 10-year note returns quicken their decline since December 2017. Not surprisingly, TIPS breakevens (i.e. inflation expectations) began to significantly widen over this same period.

All in all, investor strategies and algorithms will likely undergo a period of transition and re-writing as a new regime takes hold.

 

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