Financial Gravity and the Yield Curve

Flat Curve Winners and Losers

Let's return to an analytic technique first introduced here in February and used several times since, that of measuring the relative impact of a market factor on industry groups.

Negative numbers in the table below indicate groups benefiting from or at least not hurt by the flatter yield curve, while positive numbers indicate groups hurt by the flatter curve. The groups with statistically significant relationships (90% confidence interval) against the large-cap S&P 500, the mid-cap S&P 400 and the small-cap S&P 600 are displayed.

The list of victims is pretty clear across market capitalization levels. Utilities, REITs, oil-related groups, pharmaceuticals and financial firms, particularly thrifts and mortgages, should underperform by virtue of the flattening curve. Relative winners are in the technology sector, especially semiconductors and software, and in electrical goods manufacturing.

This list of winners and losers relative to the forward rate ratio is not significantly different from the one posted in May. As the forward rate ratio between two and 10 years has declined from 1.02818 to 1.00578 during the interim, let's see how effective the relative performance signals were.

Relative Industry Group Betas to Forward Rate
S&P 500		S&P 400		S&P 600
Group	Beta	Group	Beta	Group	Beta
IT CONS&SERV	(1.278)	COMP&PERPH	(1.091)	MARINE	(1.208)
ELEC MANU SRVC	(0.938)	AIRLINES	(1.077)	SYS SFW	(1.144)
DEPT STORES	(0.834)	SEMICONDUCTORS	(1.021)	ENVR SRVCS	(0.893)
MCYCL MANF	(0.819)	IT CNSLTNG	(0.937)	TRDNG COMP	(0.761)
COMP&ELECT	(0.723)	DIV COM SV	(0.909)	DATA PRCS & OTS	(0.749)
APPLIC SFTW	(0.697)	TRUCKING	(0.871)	SEMICONDUCTOR	(0.694)
SEMICONDUCTORS	(0.691)	OFFCE SERV	(0.832)	ADVERTISING	(0.654)
COMMERCIAL P	(0.572)	HLTHCR FAC	(0.620)	LEISURE PROD	(0.644)
RAILROADS	(0.559)	TECH DIST	(0.570)	TRUCKING	(0.579)
DIV COMM SER	(0.527)	ELE CMP&EQ	(0.503)	SPEC STRS	(0.482)
DRUG RETAIL	(0.513)			APPRL & ACCESS	(0.478)
INDUST GASES	(0.469)			COMP & EQUIP	(0.395)
SYSTEMS SFTW	(0.430)			APPL SFW	(0.372)
DATA PRCS & OTS	(0.428)
ELEC COM&EQU	(0.362)
PHARM	0.356	MLTIUTIL	0.345	GAS UTIL	0.350
DIV BANKS	0.433	ELEC UTIL	0.393	ELEC UTIL	0.378
GAS UTIL	0.461	TRFT/MRTG FINCE	0.400	REITS	0.507
REAL EST INV	0.598	PRP&CAS INS	0.404	THFT & MRTG FIN	0.635
THFTS & MRTGE	0.721	PAPER PRDCT	0.608	HOMEBUILDING	0.693
FOREST PROD	0.728	LEISURE FC	0.649	INSUR BRKG	0.811
OIL & GAS EQU	0.782	REITS	0.678	OIL&GAS EXPL	0.821
SPECIALIZED FIN	0.856	PHARMCTCLS	0.820	OIL&GAS	0.919
OIL&GAS EXPX	0.949	OIL&G STR&TRD	0.849	PAPER	0.942
OIL&GAS DRIL	1.375	OIL&G EQUI	0.853	MOV & ENTR	1.022
GOLD	2.947	MLTISECTOR	0.899	HSHLD PROD	1.091
		SOFTDRNKS	0.912	OIL&GAS REF	1.102
		OIL&G EXPL	1.062	OIL&GAS PROD	1.252
Source: Bloomberg

For this exercise, we will combine all of the S&P indices into the S&P 1500 Supercomposite. The total return of each industry group over the six months since May will be multiplied by the group's weight in the Supercomposite. Only a handful of groups had capitalization-adjusted returns of less than a -.05% contribution to the index's total return of 6.86% over this period. Three of these underperformers -- pharmaceuticals, packaged foods and thrifts and mortgages -- were expected to be affected negatively by the flatter yield curve, and they were. Pharmaceuticals in fact had the worst total return times capitalization product of any group: -0.59%.

If we move outside of the zone of underperformance, the picture starts to change. The chart below depicts the groups' whose capitalization-weighted total returns exceeded 0.05%. They are color-coded as black for basic materials, violet for utilities, turquoise for information technology, green for financials and red for energy. All others are colored white.

Capitalization-Weighted Six-Month Total Return

Source: Bloomberg

We expected the technology groups to slough off higher interest rates, a stronger dollar and a flatter yield curve -- and this certainly was true for computer hardware, communications equipment, system software, data processing and outsourcing, and semiconductors.

But what about the oil-related groups? These were expected to be affected negatively by the above-named factors, and yet their performance topped the charts. Here the answer is obvious: The financial factors affecting the oil-related issues negatively simply were overwhelmed by the unprecedented gains in crude oil, natural gas and refinery margins. Other executives might kill to have profits gaudy enough to be dragged up to Capitol Hill for a tongue-lashing.

The performance of the financial issues is fascinating. It was taken as gospel for years that this sector was one giant "carry trade" whose profits were generated from borrowing at the short end of the curve and ending at the long end of the curve. But these are not your father's financials; they make money more on trading, fees, prime brokerage and other services unrelated to the yield curve. Who knows how strong their performance would have been in the absence of the recent flattening of the curve?

Newton had one last relationship figured out: Force equals mass times acceleration. The large mass of the combined financial and energy sectors is being affected by an accelerating flattening trend both in the U.S. and in the eurozone. That force is being resisted and indeed pushed back by profit growth elsewhere and by increased risk acceptance. But it is there, pushing toward us. Just because it hasn't ruined anything yet doesn't mean it's incapable of doing so.