You might have heard: bond yields are surging. It’s sowing extreme angst in U.S. equities, which last week fell the most in two years.
And though the tumble in the S&P 500 may be nothing but a breather, concern is mounting that the Treasury market’s travails are becoming an inescapable portent for equities. Yields on 10-year Treasuries have climbed to a four-year high of 2.84 percent, from 2.40 percent at the start of the year. Here are some thoughts on why that can be bad for stocks.
A major selling point for equities since the financial crisis has been the higher yield of equities versus fixed income, with earnings considered the “yield” of a share of stock. The S&P 500’s annual profits are currently about 4.3 percent of the index’s price. While not everyone is in love with the comparison, many investors feel safe when that number is comfortably above Treasury rates — which it is, by about 1.5 percentage points. Still, the rise in bond yields has narrowed the spread to the smallest in eight years.
Another way of thinking of this is to consider valuation multiples for each security. Relative to yields, Treasuries currently trade at roughly 37 times the annual interest payout, which in a rough sense might be considered their earnings. That compares with 22.6 times profits for the S&P 500. A rise in Treasury rates to about 4.3 percent would leave the ratios even.
Again, the comparison, a version of something known as the Fed model, isn’t unanimously embraced by professionals. While viewed by many as a handy way of gauging relative value, corporate earnings and bond yields aren’t the same — they move with different volatility and different sensitivity to inflation. Still, this concept is usually in the background when people wonder about the staying power of a bull market, one that has gone for almost nine years with nary a peep out of Treasuries.
“The simplest way to look at it is, everything is relative. If you think about it, if bond yields go higher, they offer more of a reward,” said Chris Harvey, Wells Fargo & Co.’s head of equity strategy. “At the margin, the buyer, the asset owner, is slightly enticed to put more money into fixed income than into the equity market.”
Net Present Value
A related concept is net present value. Interest rates affect everything from mortgages to auto loans, but are particularly important for calculating the value of anything expected to generate profits in the future. To (over) simplify, today’s value of future earnings goes down as interest rates go up, and the risk-free payout of a bond in, say, a year, becomes more competitive.
“What is says, in general, is that higher interest rates make stocks look more expensive, especially relative to a fixed-income alternative,” said Tim Ghriskey, managing director at Solaris Asset Management. “Once yields rise to a certain level, stock investors begin to get attracted to low-risk bond yields instead of higher-volatility stock investments, and contributing to that are equity valuations above historic averages.”
Interest rates are among many factors affecting the stock market, and optimism over economic growth and accelerating corporate earnings growth may outweigh concern about rising yields, especially now, when they’re still low on a historical basis.
“There are no mechanical linkages between the Treasury market and the stock market,” said Brian Jacobsen, multi-asset strategist at Wells Fargo Asset Management. “The links are always tenuous and squishy at best.”
Straightforwardly, rising 10-year rates are a bullish signal for the economy: demand for money is rising, businesses want to put it to use. It’s the opposite of something that has bugged stock bulls for years, the flattening yield curve, which can imply moribund expectations for long-term growth. Last week, the gap between 2- and 10-year yields steepened by the most in four months.
But there’s a point where the “signal” leaves the abstract and becomes a drag on earnings. Higher rates may raise corporate expenses, which can shrink net income and compress margins. Rock-bottom financing costs have been a boon to earnings for a decade, a period in which the Federal Reserve has held rates near zero.
Policy accommodation has helped the cost of servicing debt for companies in the S&P 500 fall to an all-time low of 3.5 percent of sales over the past 12 months, according to data compiled by Bloomberg. The decline from 7.4 percent in 2007 represents $320 billion in savings and contributed to a surge of profits and a four-fold increase in stock prices.
Troublingly, the pace of growth in net operating cash flow among S&P 500 companies excluding energy and finance firms has already been declining over the past year, according to data compiled by Bloomberg and SocGen strategists including Andrew Lapthorne.
Global End of Easy Money
Yields on bonds don’t move in lockstep with Fed policy. But they’re going up now at a time when anxiety about the monetary policy is obviously on the rise. Looking at days last week, a rally that looked bulletproof around noontime Wednesday fell to pieces after policy makers added one word — “further” — to their outlook for the pace of tightening.
Nor is the Fed alone in adjusting policy — the European Central Bank has reduced its monthly asset-purchase target and hasn’t decided whether to extend buying after September. German 10-year bund yields went from 30 to 77 basis points over the past two months. The correlation between German and U.S. 10-year notes stands at north of 0.6. Rising yields in Germany has already caused the nation’s benchmark equity index to drop for seven out of the past 10 weeks.
Worries that rising bond yields signify stiffening resolve at the Fed against inflation underpin another bear case for equities: that higher finance costs will slow the economy. Buying a house gets more expensive, credit cards bite harder, consumer confidence takes a hit. All of that could result in a recession, which in the end is what most analysts say will kill the bull market.
“When interest rates rise, it makes equities look less attractive to fixed income investors, but also it chokes off economic growth,” said Rich Weiss, chief investment officer and senior portfolio manager of multi-asset strategies at American Century Investments. The firm manages $179 billion. “When longer-term interest rates rise, that tends to stem inflation and economic growth, and that feeds back into corporate profits. There’s both a market valuation explanation and a fundamental economics mechanism.”
— With assistance by Brian Chappatta, Lu Wang, and Sarah Ponczek
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