Great Stock Rotation Has Legs, Wall Street Pros Say

(Bloomberg) -- Thanks to the new-year bond selloff, Wall Street pros are doubling down on a big stock call for 2022: The leadership of high-growth tech darlings is no more.

As inflation-adjusted yields rise on conviction the Federal Reserve will tighten policy in earnest this year, Wells Fargo Securities and Morgan Stanley are telling clients to wager against high-flying technology firms that were among the biggest beneficiaries of the low-rate era -- in favor of cheaper stocks that gain from the pandemic recovery.

With the Treasury market this week signaling growing confidence on the business cycle even as the omricon variant spreads, U.S. 10-year real yields rose to -0.98% Tuesday as the nominal benchmark hit 1.65%, its highest level in almost six weeks. Right on cue, the tech-heavy Nasdaq 100 fell 1.4%, while a Wells Fargo basket of software-heavy stocks is already down 6% this week and a basket of companies vulnerable to the virus fallout is up 5%.

The upshot: The first week of 2022 trading has laid bare long-standing fears that rising bond yields are the Achilles' heel of richly valued companies -- fueling one of the biggest market rotations in years.

“If we do see real yields improve, it's going to be a much more difficult environment for tech,” Christopher Harvey, head of equity strategy at Wells Fargo said. “Especially for ‘growth at any price' stocks. The place where you should see this is your high, high growth and your high-multiple stocks.”

Wells Fargo strategists see more bad news in store for tech and expensive growth stocks this year with room for real rates to rise another 25 to 50 basis points.

Rising real rates are seen as an optimistic signal about the state of the economy, even if they send a gloomy one about stocks that were the big winners of pandemic lockdowns. The flipside is cyclical stocks such as big banks, industrial and transport firms are in line for gains.

Tech stocks -- often prized for their long-term prospects -- have become especially sensitive to bond swings as higher rates mean their future profits are worth less at present.

“What struck me about yesterday's selloff that was so important was that the bulk of the price action occurred in real yields, not in breakevens,” BMO Capital Markets strategist Ian Lyngen said Tuesday on Bloomberg TV. “So this is a growth story and not an inflation one at this point.”

Not everyone senses market disruption from real rates that remain incredibly low by historic standards and firmly within negative territory. BlackRock Inc. strategist Scott Thiel, for one, dismisses talk that they're even approaching a level where they can hurt stocks.

“We're not expecting the pace of change in real yields to be material enough to impact equity prices” over the course of the year, allowing for daily and even weekly moves, Thiel said in an interview. “To suggest that the selloff (in yields) has impacted tech prices, I think is missing the wood for the trees on where we are in real yields.”

Still a strong U.S. labor market may put the Fed on a faster tightening path and that's causing unease in the most richly-valued echelons of the stock market.

The risk is “that the Fed much more aggressively says, ‘we think real rates of interest are too low,”' Morgan Stanley strategist Andrew Sheets said in an interview. “They're going to sound more hawkish and that should bring inflation expectations down. That should bring interest rates up -- both sides of that should raise the real level of interest rate. That's generally worse the more expensive you are as a stock.”