Central banks seem to be increasingly confident that inflation will reach their targets. We raised our Fed rate hike forecast from three to four this year and from two to three next year. The rising trend in bond yields is therefore likely to continue, which raises the question whether equities will be able to continue trending upward as well. We have good reasons to believe that a gradual rise in bond yields does not pose an imminent threat to equity markets.
Markets move towards the next stage of the cycle, characterized by good macro and corporate fundamentals, but with fading support from monetary policy.
Remarkable market reaction to inflation data
February has been a quite remarkable month on the markets so far. Fears of accelerating inflation, sparked by a higher-than-expected US wage growth number, were seen as the main trigger for a surge in equity market volatility early this month. Yet, when the actual US inflation number for January was announced, which turned out to be an even a bigger upside surprise, equities sold off again but for not more than an hour. In fact, the S&P500 ended 1.3% higher that day and the Nasdaq nearly 2%, despite a rise in US Treasury yields to a 4-year high. How can these remarkably different market reactions be explained?
Maybe investors were rather relieved that the report was out than worried about the actual level. It could also very well be that they realize that a little inflation is not that bad at all for stocks. Or that the sell-off earlier this month was simply too severe in view of the fundamental picture. And apparently investors can also live with higher bond yields, coming from exceptionally low levels and the result from a strengthening economy.
How will equity markets deal with rising bond yields?
We do think that as markets move towards the next stage of the cycle, volatility may stay above the extremely low levels of the past year. This new phase will be characterized by good macro and corporate fundamentals, but with less or no support from monetary policy. Central banks are growing more confident that inflation will eventually reach their targets. We forecast four Fed rate hikes this year (up from three) and three next year, and we expect the ECB to taper its asset purchases towards zero from September to December. This will likely continue to fuel the rising trend in bond yields.
In this respect, a question that pops up is how equity markets will deal with these rising yields. We looked at previous occasions of rising rates and related it to the market performance of global equities. We looked at the 1994 bond correction, the 2013 taper tantrum and the first half of 2015. We compared a composite bond yield benchmark consisting of 60% US bond yield, 15% German, 15% UK and 10% Japanese. For equities we took the MSCI World price index in local currencies.
Equity market behaviour during previous periods of rising yields
The outcome is not straightforward and should be taken with a grain of salt, given additional factors that are at play. In all occasions, equity markets witnessed an intermediate correction but with the exception of 1994, equities ended the year in positive territory.
The recent equity sell-off was relatively fierce, taking into account the move in bond yields. This can be linked to two elements. First, the degree of investor exuberance that was visible in several market indicators. Second, global monetary policy is approaching a turning point; from synchronized accommodation via policy divergence towards synchronized tightening, even if the latter is still some quarters away and should not come as a surprise for investors.
Equity risk premium and moderate inflation are a buffer
What is also different from previous occasions is the level of the equity risk premium (ERP). In early 1994 the risk premium was less than 2.4%, so there was not a large buffer to absorb higher interest rates. By end-1994 the ERP had fallen to 134 basis points (bps), near a historic low. This is very different from today. The ERP is almost 400 bps and provides a decent buffer against higher interest rates. The 30-year average ERP is 300 bps.
Finally, rising inflation does not have to impede equity markets. Moderate inflation (i.e., not too far above target) is not a bad thing for corporate profitability. It supports top-line growth which is positive for corporate margins, especially for those companies with high operational leverage (e.g., cyclical sectors). On top of that, the current rise in inflation is still modest. For central banks it does not warrant deviation from their gradual tightening approach. Finally, equities as an asset class are positively correlated with inflation, together with commodities.
Higher bond yields benefit financials and cyclical sectors
Where rising bond yields do make a difference is on a sector level. The behaviour of utilities versus financials is a good example (see chart). The performance of the financial sector is positively correlated with bond yields, as they benefit from higher interest rate margins. In contrast, higher bond yields act as a headwind for bond-proxies like utilities and to a lesser extent real estate. The latter is partly protected against inflation through rental income indexation. Strong economic growth underpins demand for real estate, and while real estate investment trusts (REITs) have high leverage, they refinanced at low interest levels and extended the average duration of their debt.
Rising interest rates are supportive for the relative performance of cyclical versus defensive sectors. The link runs through the better economic performance. Of course, this would be very different if rate hikes were prompted by inflation that is getting out of hand. We are certainly not in such a situation today. This comforts us in our overweight of cyclicals versus defensive sectors.
Current rise in bond yields is not threatening equities
To conclude: the current rise in bond yields does not pose an immediate threat for equity markets, as it is justified by strong macro fundamentals. Meanwhile corporate fundamentals have, if anything, continued to improve with 2018 earnings estimates being revised upwards following a strong earnings season. In addition, the high equity risk premium provides a decent buffer against these higher yields. Only a big inflation scare or a policy overshoot would spell trouble. Neither is likely this year; we still expect a gradual path for both inflation and Fed rate hikes.