April 25, 2018—When it comes to bond yields, investors are impossible to please these days. If investors in 2013 were comparable to a toddler throwing a tantrum over the Federal Reserve (“Fed”) potentially withdrawing quantitative easing, then today it may be more appropriate to compare the market to a surly teenager who doesn’t know what he or she wants and is not happy no matter which direction bond yields go. For weeks, investors have expressed concern over the flattening yield curve, as measured by the difference between the yields on the 10-year and 2-year Treasury notes. (A smaller number in the 10- minus 2-year “spread” indicates flattening, and a negative number signals an inversion in the yield curve.) The 10- minus 2-year Treasury yield spread fell to a new expansion low of 0.43% on April 17. Why do investors watch the shape of the yield curve? In theory, a rising 2-year yield indicates tightening monetary policy and a falling 10-year yield signals a slowdown in inflation and economic growth in the future. Practically speaking, the yield curve has inverted, or gone negative, before each of the last five recessions. As such, investors have a heightened sensitivity for this indicator.
Given this, one may then assume that a steepening yield curve, as we have seen this week, would allow investors to breathe a sigh of relief. However, the 10-year yield touching 3% on Tuesday—for the first time in four years—was met with as much if not more angst. Despite a solid start to first quarter earnings season, stocks sold off this week, at least in part on concerns about elevated bond yields.
The 10-year yield reaching 3% is a bit of a milestone in light of a prolonged period of extraordinarily low interest rates, but we do not believe it foreshadows a declining stock market, though we could see more volatility in the short term. Corporate debt is manageable and below last cycle’s peak levels. Companies are reporting the highest profit margins since financial data company FactSet started tracking this measure in 2008, signaling higher input prices or increased debt cost can be absorbed. Valuations have reset to the lowest level in two years. From a consumer standpoint, a higher 10-year yield has coincided with higher mortgage rates, but consumers are still showing more appetite for home buying than at any other point in this expansion.
S&P 500 Index next-12-months P/E ratio
Data as of April 25, 2018
The U.S. Consumer Confidence Index
Long-term average = 100 Data as of March 30, 2018
Source: The Conference Board
Higher bond yields tend to weigh on equity sentiment for two main reasons. First, higher bond yields make fixed income—a less risky asset than stocks—more appealing. Second, higher yields translate to a higher discount rate for the future earnings growth of stocks, which necessarily makes those future cash flows less valuable. However, historically stocks have risen with yields at the beginning of the Fed’s hiking cycle. It is not until yields reach a tipping point (which has historically been around 5% for the 10-year Treasury), that stocks have suffered. Today’s tipping point is likely lower than 5%, given how low rates have been, but higher than 3%.
We are not ignoring yields—either the flattening of the curve or the upward climb of bond yields—but this is something we have been anticipating given our view of solid global economic growth and expectations for inflation closer to the Fed’s target. We also see higher bond yields overseas, the possibility of less monetary stimulus from the European Central Bank and Bank of Japan, the winding down of the Fed’s balance sheet, and increased U.S. Treasury issuance resulting from budgetary needs all lending support to a 10-year yield remaining at or above 3%. Our base case is that the 10-year Treasury yield is trading between 3.0% and 3.25% and the yield curve will not have inverted one year from now. We are closely monitoring global economic data and corporate earnings and believe we have not seen the peak in the stock market, despite a difficult start to the year. At this time we are maintaining our overweight to equities in portfolios, with a preference for non-U.S. stocks.
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