By Andrew Sheets, Morgan Stanley Chief Cross-asset strategist
From January through September, both stock markets and bond yields rose in peaceful coexistence. Over the last two weeks, that pattern has changed. It’s as if two kids sleeping in the back seat of the car have woken up, don’t know why, and definitely aren’t happy about it.
Why the sudden change?
I don’t think it’s as simple as ‘higher rates and steeper curves are bad for markets’. Though I hear this frequently, I think it’s wrong. Higher rates generally reflect more long-term economic optimism, with positives that tend to boost stock prices more than the negatives of a higher discount rate. That’s generally held true over the last 30 years, and more recently in the post-crisis period. 2009, 4Q10, 2013 and 4Q16 were among the best periods for both equity and credit returns in the last 10 years. They all had higher yields and steeper curves.
Stocks have begun reacting differently to bonds because a number of forces are colliding. How they play out will hold the key to the rest of the year.
Qualitatively, the last two weeks saw US real yields break a range that’s held remarkably stable for more than five years. Despite all that’s changed in the market narrative since June 2013, the yield on US 10-year bonds above expected inflation stayed between 0 and 90bp. While stocks historically have traded well at higher real yields, breaking a range introduces uncertainty.
Quantitatively, my colleague Michael Wilson has long flagged 3.25% as a level in the 10-year yield where, by his calculations, either the equity risk premium needs to break post-crisis lows or 2,900 becomes a ceiling for the S&P 500. While it doesn’t pay to be too precise, the stock-bond relationship did start to shift as we approached 3.25%.
These breaches collided with popular, stretched positions, most prominently value versus growth. As of early last week, value globally had not been as cheap relative to growth in nearly 20 years, and value underperformance versus growth over the last 12 months has only been worse 7% of the time. Stretched performance and valuation in turn collided with stretched positioning, making any reversal in this relationship especially painful. The rising yield/steeper curve story put a match to this tinder.
How yields rose was unusual. Yields can be seen as compensation for inflation (breakevens) and growth (real yields). The rise has been almost entirely in the latter.
While higher real rates may have benign explanations (e.g., greater optimism about productivity), there are also more ominous drivers:
- Less foreign demand, as US bonds look less attractive when hedged into foreign currencies.
- Pressure from domestic supply, with the US budget deficit now at 4%+ of GDP and climbing.
- Less central bank accommodation, with Fed balance sheet reduction accelerating to US$50 billion/month in October.
Returning to the historical data, risk assets tend to do well under higher real yields, but they prefer it when inflation expectations rise as well, perhaps because they’re consistent with broad economic optimism.
What next? The situation is far from hopeless, and there’s a plausible path to a year-end rally, but we’re not there yet.
What could drive a recovery? While recent moves have caused equity investors pain, I’d argue that it’s been mitigated overall by the popularity of being underweight duration, overweight US dollars and balanced in overall exposure. Many equity markets have now de-rated materially, and sentiment measures like Morgan Stanley’s Global Risk Demand Index and CANARIs have approached more constructive levels. 3Q earnings could shift attention away from macro challenges, and history suggests that seasonality gets a lot better after October 10.
Before that, though, issues remain to be worked through. The hit to the P&L from recent moves cannot be overstated and will curtail risk appetite. We think the market may be disappointed by a resolute-sounding Fed, as we see a very high bar to not hiking in December. 3Q earnings season may not be all good, given our concerns about elevated margins in many ‘growth’ names. And the limited scope to diversify bonds will give many investors pause.
The dangers that higher rates pose to broader markets aren’t mortal, but will take time to sort out. Those kids aren’t going right back to sleep.