Treasury yields are rising again, yet another headwind for the stock market that’s struggled to make headway this month.
With August half over, all major indexes are in the red for the month, an outlier in an otherwise robust year-to-date rally. That’s left many strategists concerned about what can keep pushing stocks higher, from renewed enthusiasm for technology such as artificial intelligence to corporate earnings.
Sevens Reports’ founder Tom Essaye has previously argued that a drop in Treasury yields could be another boost to markets, although he notes that yields represent more than just worries about ongoing interest-rate hikes from the Federal Reserve.
Many economists predict the central bank will raise interest rates at least one more time before any potential cuts next year. The general expectation is that rates will be higher for longer to combat inflation, which remains above the Fed’s 2% target. That anticipation naturally pushes up the yield on Treasuries, with the yield on the 10-year T-note reaching its highest level this year on Tuesday.
Higher interest rates are an obvious problem for many companies, because they increase the cost of capital, meaning it’s more burdensome for them to borrow the money they need for profit-fueling expansions. That’s often reflected in the stock prices of companies that need high or regular levels of cash.
However more broadly, Essaye notes that higher yields are a headwind to the market because they reduce the premium that investors expect for putting their money into what is inherently a riskier asset.
Essaye’s math for the equity risk premium goes like this: The
S&P 500
is trading at 18.68 times expected 2024 earnings per share; using an inverse of that number—1/18.68—leaves 5.3%, which is the return investors are expecting from stocks over the next year.
The problem becomes apparent when investors consider that 10-year Treasuries are currently yielding 4.23%: Why take on the extra risk of investing in stocks over bonds for just over 1% more in returns? In other words, 4.23% in the hand looks better than 5.3% in the bush.
Not only is 1% a paltry figure on its face, it’s well below the historical equity risk premium of 4%. “And given how volatile stocks have been over the past 18 months, that’s not a lot of additional reward for the incremental risk!” writes Essaye.
Other commentators have made a similar point about bonds looking like an increasingly competitive asset class; this week Charles Schwab Chief Investment Strategist Kevin Gordon highlighted how the bond market is looking increasingly attractive to yield-hungry investors, particularly as stock valuations have risen. “Higher bond yields don’t inherently imply stocks are unattractive; they just increasingly level the playing field for both asset classes.”
With yields remaining higher in lockstep with the Fed’s interest rate campaign, the only way to raise the market’s risk premium for now is for the S&P 500’s valuation to come down, providing a more attractive entry point.
“That’s why rising Treasury yields are a problem for stocks, because investors will rotate out of riskier equities and into less-risky bonds because the additional return in stocks isn’t worth the volatility,” argues Essaye, who believes that while the current environment makes the historical 4% risk premium unlikely, a “fair” number for 2023 is “definitely higher than 1%!”
Of course, Treasury yields could start falling if the Fed takes on a more-dovish tone, or we get continued, consistent evidence that inflation is cooling toward its target.
“Conversely, if the 10-year yield continues to rise and stays high, then stocks are facing a valuation headwind unlike anything they’ve seen in years (if not decades),” Essaye concludes. “And while that doesn’t mean the market is ripe for a sudden drop, it does narrow the chances of an extension of the current rally, absent a decline in yields.”
Write to Teresa Rivas at [email protected]
Read the full article here
