By Lewis Krauskopf
Thank you for reading this post, don't forget to subscribe!NEW YORK (Reuters) – Increasing U.S. Treasury yields are further enhancing the attractiveness of bonds compared to stocks, intensifying an already painful equity selloff while potentially impacting equity performance in the long run.
Bond yields close to record lows have amplified the appeal of stocks over the past 15 years, when the U.S. Federal Reserve maintained rates near zero to bolster the economy following the 2008 financial crisis.
This year’s surge in Treasury yields is altering that calculus, as government bonds provide income that is deemed risk-free for investors who hold them until maturity. The yield on the benchmark 10-year US Treasury – which moves inversely to bond prices – reached 5% earlier this week, the highest level since 2007, due to concerns about tighter Fed policy and fiscal issues. It has increased.
Consequently, numerous investors are reconsidering the extent to which stocks should be part of their portfolios. The latest survey from BofA Global Research revealed that fund managers have been favoring bonds for eight out of 10 months through 2023 and are currently allocating more than their average historical share. Additionally, they are undervaluing stocks.
The recent increase in yields, which commenced this summer, has taken a toll on stock investors. While the S&P 500 has gained approximately 9% this year, it has declined more than 8% since the end of July, when it reached its peak for the year. The 10-year Treasury yield has risen by nearly a full percentage point since that time.
“It’s not that we never had 5, 5.5% – that was the norm. What is challenging for the market is that this has not been the norm for many years,” said Quincy Crosby, chief global strategist at LPL Financial. “The market is having to adapt to a new calculation.”
Escalating bond yields increase the cost of capital for companies, thereby threatening their financial positions. Tesla CEO Elon Musk stated last week that he is worried about the impact of higher interest rates on car buyers.
Also, as bond yields rise, analysts place a higher discount on companies’ projected future earnings, as investors can now attain greater returns from risk-free government debt.
Meanwhile, the equity risk premium (ERP), which typically compares the S&P 500’s earnings yield against the 10-year Treasury yield to evaluate the relative allure of equities, currently stands at 30 basis points, whereas the 20-year average was around 300 basis points, according to John Lynch, chief investment officer of Comerica Wealth Management.
Historically, when the ERP falls below its average, the S&P 500 has displayed 12-month average returns of less than 6%, Lynch said. Conversely, when the market’s ERP surpasses that level, the forward return reaches 12%.
Investors, as well as the Fed, have been monitoring bond “term premiums” as another factor contributing to rising yields. The term premium represents the additional compensation that investors require for holding long-term debt, and it is assessed using financial models. It is currently 0.5% lower than its highest level since 2015.
Low bond duration premiums have upheld high equity valuations for most of the past decade. The forward price-to-earnings ratio of shares over the last 10 years has averaged 17.8%, while the term premium has averaged -0.3%. In comparison, the historical average forward P/E is 15.6, with a term premium of 1.4% since 1985.
If higher interest rates impede economic growth, as projected by many analysts, current equity valuations may also hinge on overly optimistic earnings projections.
As it stands, analysts anticipate a 12.1% growth in earnings for S&P 500 companies in 2024, according to LSEG IBES.
“If we have really extremely high interest rates, that goal will be hard to achieve,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management.
John Hancock Investment Management recommends a slightly higher allocation to bonds. Similarly, LPL Financial also suggests a modest overweighting in fixed income.
Despite rising rates, some investors believe that stocks may remain resilient.
Analysts at UBS Global Wealth Management stated in a recent note that the level of the equity risk premium “does not appear worrisome,” highlighting that the level was even lower from 1980 to 2000.
Furthermore, according to Keith Lerner, co-chief investment officer of Truist Advisory Services, the 10-year yield averaged 6.2% from 1950 to 2007, with the S&P 500’s annual compound return over this period being 11.9%.
“My message would be that just because you have more competition from cash and Treasuries, don’t be overly negative on equities, because that’s historically been the norm,” Lerner said.
(Reporting by Lewis Krauskopf; Additional reporting by Dan Burns; Editing by Ira Iosebashvili and Marguerita Choy)
Source: ca.finance.yahoo.com
