Yields on 10-year Treasury yields have surged well above 4%. This creates increased competition for stocks, which are riskier than Treasurys. With both stock valuations and interest rates high, stock prices could continue to fall. Stocks have surged in recent months as the US economy has proved resilient: job gains remain positive, the unemployment rate is remarkably low, and GDP is expanding.
But as investors have celebrated the growing likelihood of a soft-landing outcome — where the economy avoids a recession — another threat to this year’s rally has emerged in the form of rising interest rates.
Yields on 10-year Treasury notes surged to 15-year highs this week, surpassing 4.3% for the first time since late 2007. This has put a damper on what was a 20% rally for the S&P 500 from January to the end of July. So far in August, the benchmark index is down 5%.
Treasury yields are rising for a number of reasons. One of them is that core inflation, which discounts the more volatile food and energy prices, is still too high at 4.7%. This means the Fed is likely to keep rates higher for longer and could hike rates again this year. Another reason is that the US Treasury is issuing more bonds to fund government spending, meaning a higher supply of the assets on the market.
Rising Treasury yields hurt stocks because they mean greater competition for investors’ money, according to Adam Turnquist, the chief technical strategist at LPL Financial. Treasurys are considered-risk free assets, so when guaranteed annualized yields rise above 4%, they become a more attractive option relative to risky stocks than when yields are, say, below 2% like they were in early 2022, all of 2021, and all of 2020.
Here’s the equity risk premium, or the annualized excess return investors can expect by putting money in the stock market versus the 10-year Treasury note. It’s currently at its lowest level since 2004, the Bank of America chart below shows.
Bank of America The equity risk premium is based on stock market valuations, or how expensive stocks are relative to earnings. Higher valuations typically mean lower long-term annualized returns, and vice versa.
Valuations are indeed on the higher side. According to FactSet data published on August 4, both forward and trailing 12-month price-to-earnings ratios for the S&P 500 are above their five- and 10-year averages.
Here’s the S&P 500’s trailing 12-month P/E ratio. Its five-year average is shown in the green dotted line, and it’s 10-year average is shown in the blue dotted line.
Factset And here’s the same comparison on a forward basis.
Factset In a July client note, Comerica Wealth Management’s CIO John Lynch said stock valuations were too high for where Treasury yields were historically.
“Over the past 50 years, when the yield on the 10-year U.S. Treasury note has been between 3-4%, the S&P 500 Index has traded—on average—at 17.3 times trailing one-year earnings,” he said. According to Wall Street Journal data, the S&P 500’s current trailing 12-month P/E ratio is 20.37.
Assuming yields don’t fall, the only way for the equity risk premium to improve is for stock valuations to fall. That would mean stock prices would have to drop if earnings expectations don’t grow.
“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),” said Tom Essaye, founder of Sevens Report Research. “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.”
Again, stocks have fallen about 5% since the start of August. According to Lynch, if valuations fall to be more in line with 10-year Treasury yields in a 3-4% range, the S&P 500 would be more fairly valued at 4,150-4,200. That would mean the S&P 500 falling almost another 5%.
Macro still mattersThe points above are a reflection of how rising yields can impact stocks on a short-term, technical basis. But higher yields also mean pressure on the economic growth going forward, Turnquist told clients to remember.
The Fed is raising interest rates to cool off the economy to slow inflation. According to David Rosenberg, the founder of Rosenberg Research who called the 2008 downturn, 80% of Fed hiking cycles have resulted in a recession.
And leading economic indicators do point to trouble ahead. The Treasury yield curve is inverted like it has been prior to every recession since the 1960s, reflecting heightened investor concerns about the economy’s near-term prospects.
The Conference Board’s Leading Economic Index is also in recession territory. The gauge takes into account manufacturing activity, consumer sentiment, lending activity, housing market activity, and more.
The Conference Board If a recession does hit, a more meaningful sell-off than one driven by valuation reversion is likely. According to RBC, the average S&P 500 decline during a recessionary period is 32%, with a range of 15% to 57%.
Many strategists and economists calling for a recession say it will be mild given the strength of the consumer following COVID-19-related stimulus. A mild recession would probably translate to a more mild stock sell-off.
The median S&P 500 year-end price target among major Wall Street strategists is 4,300, just below the index’s current price around 4,370. Some of the more bearish targets include BNP Paribas’ Greg Boutle at 3,400, Cantor Fitzgerald’s Eric Johnston at 3,500, and Piper Sandler’s Michael Kantrowitz at 3,700.
How far the current reversal ultimately goes in the long-run will be influenced by how the labor market and economic growth fare. Elevated rates over an extended period of time put both at risk of deteriorating.