Inflation, Treasury volatility and risky growth stocks
With inflation reaching more than 4% recently from 2.6% about a year ago, concerns about longer-term inflation have become in the spotlight. The Fed’s easy money policies and government stimulus spending have pushed growth and momentum into an epic bull run over the past year. However, these equity factors are now facing substantial risks linked to the volatility of the bond markets.
Often underestimated, implied cash volatility (TVOL) is a measure of the uncertainty reflected in the prices of options on 10-year yields. This implied volatility traps all kinds of valuable economic information such as inflation expectations, unemployment and the stance of monetary policy.
Increases in TVOL are negatively related to aggregate market returns, as rate uncertainty makes stocks riskier due to the discounted component of future cash flows. The graph below shows the relationship between aggregate market returns and the change in TVOL over 10 years. All TVOL metrics are taken from the over-the-money (ATM) futures options located on the OptionMetrics volatility surface.
It is obvious that a rise in TVOL creates real headwinds for the entire equity market. However, rate uncertainty should not be expected to affect all securities equally. Financial theory tells us that sectors should have different exposure to changes in interest rates, namely growth and value. Growth stocks are expected to generate greater cash flow going forward. As a result, rising rates should compress their valuations.
90-day rolling correlations are plotted for low Book-to-Market (B / M), or growth, and high B / M, or value, returns and TVOL changes in the following chart.
The sensitivities of growth and value to rate uncertainty follow each other quite closely historically. However, growth and value exposures start to diverge considerably from 2021. While the high B / M portfolio has a close to zero correlation with TVOL at the end of January, low B / M stocks exhibit strong negative sensitivity. close to -0.5. Therefore, increases in TVOL impose much larger losses on growth relative to value.
FAANG stocks (or the most important US tech stocks: Facebook, Amazon, Apple, Netflix and Google) are now increasingly sensitive to inflation news, with rising rates compressing their valuations. This should fuel volatility until mid-June when important economic data is released.
Critical dates for this industry are the non-farm payroll news on June 4 and the core CPI numbers on June 10. These dates are known ex-ante periods of increased risk to technology with higher than expected employment or CPI, which can cause continued inflation anxiety for investors.