US 10-year Treasury yields cross the 3% mark: What’s the tipping point for equity markets?

US 10-year Treasury (UST) yields have crossed the 3% mark (+60 basis points (bp) year-to-date), a level not seen since December 2013.

Stock market turmoil experienced in late January highlighted the strong link that exists between interest rates and equities, especially when moves on rates are abrupt. Theoretically, the impact of higher nominal rates and inflation on corporate earnings is ambiguous as multiple transmission channels can work in opposing directions. The effect on valuation is more straightforward: higher rates reduce the net present value of expected cash flows.

Empirically, inflation above 2% has coincided with equity outperformance against bonds over the last decades. At the same time, UST at 5% or more has tended to be negative for equities. Given the new post-crisis paradigm of lower potential growth, it is highly possible that the crossing point will be earlier this cycle. Our analysis shows that real rates moving above US potential growth would be a warning sign. Using current estimates of potential growth (1.6%-1.8%), real rates might still have 80bp to go before they affect equity markets.

As inflation normalises – and, in turn, monetary policy – volatility episodes such as the one experienced in February seem inevitable. With trade tensions easing - at least temporarily - over the past week, rates have resumed their uptrend, heading now to 3% on the 10-year treasury yields.

Short-term, the sustained rise in commodity prices is likely to underpin inflation expectations further, while the expansionary fiscal plan implemented late cycle (i.e. when the labour market is already tightening) poses a medium-term risk.

Interestingly, the breakevens are not the main drivers of the recent rise in bond yields, but the real rates. Indeed, US 10-year real rates are up nearly 40bp year to date, while breakevens are up only 20bp. Bond investors price in the fact that rising inflation could ultimately push the US Federal Reserve (Fed) to turn more restrictive and accelerate the ongoing monetary policy tightening.

We have long held the view that a reflationary environment, characterised by a rise in inflation breakeven, was generally positive for cyclical assets and pro-risk portfolio positioning. Over the last decades, global equities have outperformed bonds when US inflation has accelerated above the 2% threshold. However, empirically we found no evidence of a link (positive or negative) between real rates and the performance of risky assets.

In this note, we analyse the relationship between inflation, bond yields and stock markets – which is clearly not linear but rather highly dependent on the corporate sector’s financial situation, the monetary stance and the level of real rates relative to potential growth.

Rates, inflation and corporate earnings

The impact of higher nominal rates and inflation on corporate earnings is difficult to define as there are various direct or indirect transmission channels acting in opposing directions:

• a) higher inflation means higher revenues (+);
• b) higher inflation usually means higher wages – i.e. higher costs – which may or may not, depending on operating leverage, deteriorate corporates margins (+/-);
• c) depending on the point in the cycle, higher nominal rates can be either a reflection of improved activity or a catalyst for a slow down in investment (in turn, suggesting that an economy may be edging into overheating territory) (+/-);
• d) higher nominal rates mean higher financing costs and interest burden (-).

We think that the current repricing of interest rates reflects expectations for stronger nominal growth, acknowledging the impact of the expansionary fiscal policy announced in the US earlier this year. We have upwardly revised our growth and inflation forecasts for 2018 accordingly. This stronger growth outlook implies not only increased revenue growth but also margin expansion. Indeed, empirically, we found that periods of rising wages coincide with periods of rising margins: corporate managements are more inclined to raise wages when their assessment of the economic outlook is positive (i.e. when they expect an operating leverage of greater than one). The current estimate for operating leverage for the S&P 500 is significantly above two, while guidance from the last earnings season proved particularly optimistic on the economic outlook and capital expenditure.

Interest expense reduction has been a significant driver of profit growth during this cycle. A negative feedback loop could materialise if financial conditions deteriorate abruptly and weigh on the economic backdrop and revenues, while a rising hurdle rate for nominal investment might limit the funding of new projects.

Ultimately, interest expenses are likely to rise gradually as the share of newly issued debt increases. Since 1990, earnings recessions – and economic recessions¹ – generally occurred when the Goldman Sachs US Financial Conditions index exceeds 100. This indicator is built on a set of financial variables that are likely to affect the funding conditions faced by US companies, the biggest contributors being credit spreads and interest rates. The recent moves in rates lifted the index from 98.2 to 98.7 – still well below the 100 threshold. As such, this indicator is still close to its historical lows, meaning that the financial conditions are not yet in restrictive territory.

The speed of adjustment is key – obviously, the slower the better. Firstly, the current tightening cycle initiated more than two years ago by the Fed is atypical, of course, in terms of the initial level of Fed Funds (0.25%), but also more strikingly in terms of the pace of the hikes.

So far, the Federal Open Market Committee (FOMC) has adopted a very cautious stance, adapting its tightening cycle to the financial environment. Even if some concerns might arise as Jerome Powell adjusts to his role as Fed chairman, we see little risk of a dramatic change in Fed monetary policy in the coming quarters. This is significantly different from past tightening cycles (when rate hikes happened at a much faster pace) and past interest-rate shocks.

Secondly, after more than seven years of ultra-low interest rates, we think that companies may be less sensitive to a rise in interest rates for two key reasons: i/ the predominantly fixed and long-dated debt issued over the past credit cycle and; ii/ the high cash balances held by corporates. Consequently, the average interest rate paid by US high yield companies (ex-commodities) is historically low and uncorrelated to sovereign yields. Between 2011 and 2015, it fell from 9.4% to 6.5% while the US 10-year yield was up 120bp. Since then, it has remained very stable, between 6.5% and 6.8%. The same applies to S&P 500 companies, for whom average interest paid is approximately 300bp lower.

As such, we believe earnings will continue to benefit from higher inflation as the current level of interest rates (still well below nominal growth) do not significantly affect economic activity. The on-going reporting season is likely to deliver a positive surprise, highlighting a healthy revenue growth in the US and Europe. Against this backdrop, the consensus expects earnings growth of 19% in the US this year (+14% for the MSCI World).

Rates, inflation and equity valuations

The current level of inflation is not a problem in and of itself: we showed that periods with positive albeit limited inflation, i.e. between 1% and 3%, are associated with the highest price/earnings ratios² . Going forward, we (and the consensus) expect inflation to rebound from its current level and move closer to its long-term upper bound (core Personal Consumption Expenditure Price Index close to 2%) in line with accelerating economic growth and a tightening labour market. From an historical standpoint, these levels are not a cause for concern. However, exiting the post-global financial crisis period (characterised by long-lasting deflationary fears), markets are becoming more nervous as these figures might be getting closer to the Fed’s inflation target.

Rather than the level of inflation, the volatility of inflation should be closely monitored as it might eventually translate into higher risk premium and lower valuation metrics. Indeed, even if earnings remain robust, higher discount rates automatically reduce the net present value of future cash flows³. Uncertainty concerning inflation and the ability of the Fed to keep it under control can translate into higher real rates: while higher breakevens reflect expectations of higher inflation, higher real rates can reflect fears of unexpected inflation and perception of a Fed behind the curve. That said, unlike the experience of the 80s and 90s, we think that today’s monetary policy – encompassing forward guidance and increased confidence in the anchoring of inflation expectations – is likely to curtail these uncertainties and limit the rise in real rates. Coming into 2018, we shared our view that the high equity valuations witnessed in 2017 were consistent with the so-called “Goldilocks” economic backdrop. However, we said that rising uncertainties surrounding inflation and monetary policy were likely to dampen the outlook. Indeed, the latter tends to fuel higher real rates and, in turn, lower valuations. As such, our expectations for US equity indices in 2018 encompassed a de-rating that materialised throughout the recent market sell-off.

Finally, the level of rates also affects relative valuation and asset allocation flows, with income investors rotating as bond yields compete with shareholder yield (dividend + buybacks), especially at the end of a rising rate cycle. In the US, the spread between the S&P500 earnings yield and the investment-grade bond yield is still well above the historical average (63bp) at 105bp, supporting the relative valuation case for equities.

When might the turning point come?

As we have shown, a number of factors influence the relationship between interest rates, inflation and equity markets. In our view, the most important are:

1. The inflation/monetary policy regime: during the “great inflation” period, the equity-rate correlation was negative, meaning that an increase in rates hurt equity markets. Since the end of the 90s and as the credibility of the central banks has improved, inflation expectations have become more anchored, leading to a negative equity-rates correlation.
2. Position in the cycle: the earlier in the cycle the better, as valuation – and consequently the potential drawdown – tends to be higher when the business cycle matures. The current situation is quite unusual as the US economy is already in the late stage of its cycle but earnings growth should be underpinned by the expansionary fiscal plan over the coming quarters.
3. The origin of the rise in interest rates: real rates (negative impact on equity valuations) versus inflation breakevens (positive for equities). Since August 2017, the rise in nominal rates has come almost equally from real rates and inflation breakevens.

Historically, 10-year UST yields at 5% or more have been definitively negative for equity returns. However, the crossing point is likely to occur earlier this cycle as we have moved into a low-potential growth economy, which started in 2000 (potential growth more than halved from 4% in 2000 to 1.7% today, according to the Federal Reserve of Saint Louis). We observe that the equity/rates correlation turns negative (i.e. rates start to hurt equity markets) when real rates move closer to potential growth.

Currently trading between 0.7 and 0.8%, 10-year US real rates are still well below US potential growth (estimated between 1.6 and 1.8%), meaning that real rates still have 80bp to go before significantly weighing on equity markets.