Soaring Treasury yields threaten long-term performance of US stocks
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[October 26, 2023] By
Lewis Krauskopf
NEW YORK (Reuters) - Soaring U.S. Treasury yields are further boosting
the appeal of bonds over stocks, deepening an already painful equity
selloff while threatening to weigh on equity performance over the long
term.
Bond yields near historic lows bolstered the attractiveness of stocks
over the past 15 years, when the U.S. Federal Reserve kept rates near
zero to support the economy following the 2008 financial crisis.
This year’s climb in Treasury yields is changing that calculus, as
government bonds offer income that is viewed as risk-free to investors
who hold them to term. The yield on the benchmark 10-year U.S. Treasury
- which moves inversely to bond prices - hit 5% earlier this week, its
highest level since 2007, in a climb fueled by hawkish Fed policy fears
and fiscal worries.
As a result, many investors are recalibrating how big of a role stocks
should play in their portfolios. Fund managers have been overweight
bonds for eight out of 10 months of 2023 and are currently above their
average historical allocation, the latest survey from BofA Global
Research showed. At the same time, they are underweight stocks.
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The latest spurt higher in yields, which began this summer, has taken
its toll on stock investors. Although the S&P 500 is up about 9% for the
year, it has slid over 8% since late July, when it peaked for the year.
The 10-year Treasury yield has climbed about a full percentage point
since then.
“It isn’t as if we have never had 5, 5.5% - that was the norm. What is
difficult for the market is that has not been the norm for many years,”
said Quincy Krosby, chief global strategist for LPL Financial. “The
market is having to adjust to a new calculus.”
Rising bond yields raise the cost of capital for companies, threatening
their balance sheets. Tesla CEO Elon Musk said last week that he was
concerned about the impact of high interest rates on car buyers.
At the same time, companies’ projected future profits are more heavily
discounted in analysts’ models when bond yields rise, as investors can
now get a higher reward from risk-free government debt.
Meanwhile, the equity risk premium (ERP), which typically pits the S&P
500's earnings yield against the 10-year Treasury yield to determine
equities' relative attractiveness, recently stood at 30 basis points,
compared with a 20-year average of about 300 basis points, according to
John Lynch, chief investment officer at Comerica Wealth Management.
Historically, the S&P 500 has shown average 12-month returns of less
than 6% when the ERP falls below its average, Lynch said. In contrast,
when the market’s ERP surpasses that level, forward returns approach
12%.
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Traders work on the floor at the New York Stock Exchange (NYSE) in
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Investors, as well as the Fed, have also eyed bond "term premiums"
as another factor pushing yields higher. The term premium is the
added compensation investors expect for owning longer-term debt and
is measured using financial models. It currently stands at its
highest level since 2015 at just below 0.5%.
Low bond term premiums have been supportive of lofty equity
valuations for most of the last decade. Stocks have averaged a
forward price-to-earnings ratio of 17.8 over the last 10 years,
while the term premium has averaged -0.3%. That compares with a
historical average forward P/E of 15.6 and a term premium of 1.4%
since 1985.
Current equity valuations also may be banking on overly optimistic
earnings estimates, if the higher interest rates slow the economy as
many analysts expect.
As it stands, S&P 500 companies are expected to increase earnings by
12.1% in 2024, according to LSEG IBES.
“If we have really prohibitively high interest rates, it is going to
be hard to hit that target,” said Matthew Miskin, co-chief
investment strategist at John Hancock Investment Management.
John Hancock Investment Management is recommending a modest
overweight to bonds. Similarly, LPL Financial also is recommending a
modest overweight to fixed income.
Despite the rising rates, some investors said stocks can remain
resilient.
Analysts at UBS Global Wealth Management said in a note this week
that the level of the equity risk premium "does not look alarming,"
noting the level was even lower from 1980 to 2000.
Meanwhile, the 10-year yield averaged 6.2% from 1950 to 2007, a
period that saw the S&P 500’s annualized compounded return at 11.9%,
according to Keith Lerner, co-chief investment officer at Truist
Advisory Services.
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“My message would be don’t get overly negative on equities just
because you have more competition from cash and Treasuries, because
that is historically the norm,” Lerner said.
(Reporting by Lewis Krauskopf; Additional reporting by Dan Burns;
Editing by Ira Iosebashvili and Marguerita Choy)
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