Growth Stocks Drop as Rates Rise

Short-term rates have more than doubled from their June levels albeit from low levels. Over this period, the 2-year Treasury note yield has risen from 0.14% to 0.30% with the most prominent reason being expectations of the Fed tapering asset purchases. Even the 10Y yield has increased from 1.15% to 1.5%. Longer-duration yields are more tied to perceptions of economic growth and inflation expectations vs shorter-term instruments more influenced by Fed policy.

The last time that we saw a sharp rise in short-term rates was from mid-January to late March when the 10Y rose from 1.05% to 1.7%. It wasn't a coincidence that this coincided with a brutal period for growth stocks that sustained heavy losses. Since then, some growth stocks have recovered and gone on to make new highs while others remain near their lows.

The last decade has seen a consistent downtrend in rates despite large fiscal deficits and generous monetary policy. It's also featured outperformance from growth stocks and constant inflows into the stock market. When rates are rising, bonds are competing for capital so market pullbacks tend to be more volatile.

Additionally, growth stocks' high multiples can be more easily justified during periods of low rates. However, projections about future profitability have to take interest rates into account. When the risk-free rate of return increases, it makes the projected return on a speculative investment less attractive.

Earlier this year, we saw major pullbacks in terms of cloud computing, work-at-home, e-commerce, electric vehicles, and other growth categories of between 20% and 40%. Currently, we are seeing about 10% corrections in many growth stocks but these could easily compound if rates rise more.

And, there are some good reasons to expect rates to rise - despite the public rancor, it still seems more likely that some sort of infrastructure and reconciliation package is passed; coronavirus case counts continue to plummet; and longer-term inflationary indicators continue to perk up even if, in the short-term, inflation could recede as supply chain issues get sorted out.