The recent surge in US bonds yields has caught the attention of investors worldwide and forced a re-think over the equity outlook. This note suggests, however, that higher rates need not kill the bull market anytime soon, provided corporate earnings remain upbeat and inflation contained.
Market comes around to the Fed’s thinking
As evident in the chart below, last week US 10-year bonds yields spiked up from 3.06% at the start of last week, to 3.24%. As recently as late August 10-year year bond yields were still only around 2.8%.
Why did yields surge? Technically, the market was vulnerable as yields had recently pushed through the psychologically important 3% level in recent weeks, and the floodgates opened once the previous high of around 3.11% was breached. Fundamentally, the drumbeat of strong US economic data has continued and the Fed has reiterated its view that it will likely need to raises rates several more times in 2019. The Fed’s projections currently imply a further 1 percentage point lift in the Fed funds rate, from 2-2.25% to 3-3.25% by end-2019.
Long-run rates could soon stabilise again
For those concerned about the risk of a US recession, however, last week’s market moves contain at least some good news – the yield curve (as measured by the gap between US 10-year and 2-year bond yields) steepened. That’s somewhat reassuring given that most US recessions (and equity bear markets) are usually preceded by this yield gap turning negative.
Indeed, as evident in the chart below, the yield curve also steepened during the two previous periods of strong 10-year bond yield increases, in late 2016 and early 2018, only for longer-term bond yields to then stabilise for a time. This is consistent with the view that market reassessment of Fed policy is initially most reflected in longer-term rates, which often then stabilises as shorter-run rates more slowly adjust to the new reality.
If so, this suggests 10-year bond yields may already be close to reaching their highs for the next few months and may well stabilise somewhat from here.
Still scope for equities to withstand higher yields
All that said, higher bond yields nonetheless pose challenges for the equity market. As seen in the chart below, there is a broad negative (but far from perfect) correlation between bond yields and US equity valuations over time. As at end-September, this broad valuation tool suggested the equity market was reasonable value. Were 10-year bond yields to rise to, say, 3.5%, this valuation framework would imply a fair-value PE at around 15.7, or 6% below end-September levels.
That leaves the other driver of equity prices – corporate earnings. As seen in the chart below, thanks in part to tax cuts, US earnings expectations have been generally revised up over the past year. Based on current consensus Bloomberg expectations, forward earnings should rise by around 10% between now and end-2019.
At face value, if the US PE ratio fell to 15.7 next year and earnings rose 10%, it would be consistent with 4% growth in the S&P 500 Index – which is not great by recent standards, but still far from bear market territory.
From a longer-run perspective, moreover, the chart below shows that an upward trend in bonds yields has generally been a headwind – but not an immediate death knell – for equity bull markets since at least the late-1990s. Indeed, rising longer-term rates are generally part and parcel of a growing economy with good corporate earnings.
But keep a careful watch on inflation!
Of course, the above analysis remains predicated on US price and wage inflation remaining reasonably well contained. If these start to rise strongly, all bets are off – as the Fed would likely raise rates more aggressively, causing at least a garden-variety bear market in which equity prices could potentially decline by at least around 20%.
Ironically, this would likely also be a time when long-term bond yields peak and eventually start falling!