Airtight Reopening Trade Springs a Leak With Bonds Rebounding

This past week was a warning to bulls that the rotation trade, in which billions of dollars have been plowed into smaller companies battered by the coronavirus, is far from foolproof.

Even with a 4.1% two-day rally, the Russell 2000 ended the week 2.9% lower for its worst drop in four weeks. Meanwhile, the tech-heavy Nasdaq 100 gained 0.9% for the week, a reversal of the market leadership that prevailed throughout 2021.

Upsetting the equity leaderboard was a rally in Treasuries, where yields dropped after a seven-week climb. While an ambitious U.S. vaccine rollout, brightening economic forecasts and $1.9 trillion of government aid have pressured rates higher, the selloff cooled after hitting oversold levels and as traders reassessed the inflation outlook. That sent a shudder through small caps, which have surged as markets priced in expectations of booming growth.

“The stock market had already priced a continuous selloff in the bond market. The shock is when the bond market doesn’t sell off, and that’s when you see the rotation back into tech,” said Gina Martin Adams, chief equity strategist for Bloomberg Intelligence, in a Bloomberg Television interview. “The shock now is not yields rise, the shock is, oh maybe yields don’t rise, and the result of that is really messy leadership.”

Airtight Reopening Trade Springs a Leak With Bonds Rebounding

Relatively placed moves in major indexes masked harrowing volatility in several corners of the stock market this week. Losses were pronounced in Chinese technology stocks, with depository receipts of Tencent Music Entertainment plummeting 34%. Baidu Inc. fell 19%.

And even as reopening trades were getting battered, a group of stocks that became fashionable as pandemic lockdowns kept people indoors -- media companies that sell streaming services -- were some of the week’s biggest losers. ViacomCBS Inc. and Discovery Inc., which ran up in almost identical 150%-plus rallies between January and mid-March, both lost roughly half their value over the five days as Wall Street valuation warnings came fast and furious.

The Russell 2000 has rallied 12.5% so far this year as benchmark 10-year Treasury yields climbed to pre-pandemic highs, breathing life into cyclical sectors such as banks and industrials. That compares with a 5.8% rise in the S&P 500 and a 0.7% gain for the Nasdaq 100. The Russell 2000 is roughly 88% higher over the past year, trouncing gains of 64% and 51% for the Nasdaq 100 and S&P 500, respectively.

The scale of that outperformance prompted Morgan Stanley to downgrade small caps last week, followed by UBS Group AG analysts walking back their call for small caps to best their larger peers. Stocks considered most sensitive to 10-year Treasury yield fluctuations are priced for another 15 to 25 basis point rate rise, leaving them vulnerable should it not materialize, the UBS analysts wrote.

“The outsized rotation also suggests there could be some tactical reversal if yields settle down,” analysts led by Keith Parker wrote in a note this week. “Reopening and reflation trades outperformed their respective rate-implied moves -- with airlines and hotels as well as metal and construction well above what was implied.”

Helping to stoke the rebound in Treasuries was Federal Reserve Chairman Jerome Powell, who reiterated over four separate public appearances that the Fed won’t put away its toolkit until the economy is “all but fully recovered” from the coronavirus shock. That echoes his sentiments from last week’s Fed policy decision, where Powell said it’s not yet time even to begin discussing reducing the central bank’s asset purchases.

While the fall in 10-year yields from 1.71% on Monday to about 1.67% on Friday rattled the rotation trades, small-cap believers such as RBC Capital’s Lori Calvasina remain bullish -- though she concedes that the rally won’t be straight-up.

“We’ve viewed this as a longer-term call and have been prepared to ride out any short-term underperformance that might occur in a broader pullback, something we have viewed as inevitable this year,” wrote Calvasina, the bank’s head of U.S. equity strategy.

©2021 Bloomberg L.P.

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