Stock Market Meltdown for Bond Proxies in Worst Week Since April

  • Shares adding to declines amid hawkish comments from Fed
  • Utility shares sensitive to higher rates decrease the most

Increasingly hawkish Federal Reserve rhetoric is making a bad stretch worse for stocks investors fell in love with for their high dividends.

Utilities dropped for a fifth straight day Thursday, leaving them poised for the worst week since April. Real estate and consumer staples shares were also in retreat as the odds for higher interest rates this year pushed past 55 percent. The S&P 500 fell 0.9 percent to 2,152.27 at 1:22 p.m. in New York, with financial shares joining the retreat amid growing concern that Deutsche Bank AG’s woes could spread.

Losses for companies broadly defined as bond surrogates mark a continuation of a trend that’s held since the middle of the year, when utilities, drugmakers, real-estate and staples shares began to weaken. An exacerbating influence is the relative size of the industries: according to Ned Davis Research, stocks in the category trade with a higher market capitalization compared to industries like banks than any time since the bull market began in March 2009.

“To the extent that there’s a concern about potentially higher interest rates and a stronger economy, there are going to be high-yielding areas that lag behind,” said Kevin Caron, a Florham Park, New Jersey-based market strategist and portfolio manager who helps oversee $180 billion at Stifel Nicolaus & Co. “Particularly utilities, which have had a pretty decent run this year. With valuations where they are, they were probably due to take a breather.”

Just a week after the Fed Chair Janet Yellen sparked a 1.1 percent rally in U.S. stocks after keeping interest rates steady, a handful of central bank officials have publicly endorsed a rate hike in the near-term. Fed Bank of Atlanta President Dennis Lockhart on Thursday said the central bank is nearing its goals of maximum employment and steady inflation near 2 percent, a day after Chair Janet Yellen testified that jobs growth will likely soon warrant tighter policy.

Utility stocks in the S&P 500 have a price-to-earnings ratio of 18.3, almost 25 percent above the 10-year average, according to data compiled by Bloomberg. They’re also trading at a 16.8 percent premium to financial firms and other companies poised to profit from higher lending costs on a market capitalization basis, John Lyon, a U.S. market analyst at Ned Davis, wrote in a Sept. 22 client note. That’s the most since the start of 2009.

Lyon recommends fund managers capitalize by buying financial shares, which have historically performed well when the spread has exceeded 14 percent, what Ned Davis defines as the overbought threshold.

Financial shares joined utility and health-care shares in retreating Thursday, with banks erasing an early gain after concern spread that Deutsche Bank AG’s woes will spread to the global financial sector.

“The Deutsche Bank situation is major. This is a huge bank,” said Timothy Ghriskey, who helps manage $1.5 billion as chief investment officer at Solaris Asset Management LLC in New York. “Deutsche Bank has potential ramifications given cross relationships with other banks. I’m not saying this is the beginning of a global financial crisis, aka 2008, but it’s certainly a cause for some concern.”

Bloomberg News reported that a number of funds that clear derivatives trades with Deutsche Bank AG have withdrawn some excess cash and positions held at the lender, a sign of counterparties’ mounting concerns about doing business with Europe’s largest investment bank. The firm had already fallen to all-time lows on Monday amid concerns that mounting legal bills may force the lender to raise capital.

Equities fluctuated earlier Thursday as energy shares advanced, while dividend payers slid amid Lockhart’s comments saying the central bank is nearing its policy goals, leaving the economy primed for an increase in borrowing costs. Philadelphia Fed President Patrick Harker earlier said policy makers should begin raising rates to get ahead of inflation and avoid “falling behind the curve.”

“Utilities are taking a beating since they trade as an alternative to bonds,” said Peter Jankovskis, who helps oversee $1.9 billion as co-chief investment officer of Lisle, Illinois-based Oakbrook Investments. “Perhaps that reflects people thinking about the latest statements from Fed officials.”

The central bank’s decision to hike rates could be expedited by an improving outlook for inflation. On Wednesday, bond investors raised their expectations for inflation in the U.S. and U.K. after OPEC’s deal to cut crude output for the first time since 2008 renewed expectations of higher energy costs. Economists surveyed by Bloomberg now see a 56 percent chance of a rate hike before the end of 2016, up from 40 percent at the start of September.

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