NEW YORK- As the Federal Reserve’s hawkish stance boosts Treasury yields and slams stocks, some investors are preparing for more pain ahead.
For most of the year, equity investors brushed off a rise in Treasury yields as a by-product of better-than-expected economic growth, despite worries that yields could eventually weigh on stocks if they rose too high.
Those concerns may be taking on fresh urgency after the Fed last week forecast it would leave rates elevated for longer than many investors were expecting.
Following a 1.5 percent tumble on Tuesday, the S&P 500 is now down more than 7 percent from its July highs, stung by sharp declines in shares of some of this year’s biggest winners — including Apple Amazon.com and Nvidia At the same time, yields on the US benchmark 10-year Treasury stand near a 16-year peak at 4.55 percent .
With policymakers projecting rates will remain around current levels until the end of 2024, some investors say more volatility could be in store. Higher yields on Treasuries – which are sensitive to interest rate expectations and seen as risk free because they are backed by the US government – offer investment competition to stocks while raising the cost of borrowing for corporations and households.
The market “is recalibrating what is the right valuation for equities in a 5 percent interest rate world,” said Jake Schurmeier, a portfolio manager at Harbor Capital Advisors.
“Investors are asking, ‘Why do I need to (take) equity risk when I get more returns than that just by holding a Treasury bill?’”
If history is any indication, higher rates are a less favorable environment for equity investors. An analysis by AQR Capital Management going back to 1990 showed US equities returned an average of 5.4 percent over cash when rates were above their median level – as they are now – compared with a return of 11.5 percent when interest rates were below their median.
“Stock markets are just plain expensive,” said Dan Villalon, principal and global co-head of portfolio solutions at AQR Capital Management, who believes rates will be higher over the next five to 10 years than in the previous decade, impacting returns.
AQR’s analysis showed that trend-following hedge funds tend to outperform when rates are elevated, as they hold large cash positions that benefit from higher rates.
The equity risk premium, which compares the attractiveness of stocks over risk-free government bonds, has been shrinking for most of 2023 and was last around its lowest levels in about 14 years, according to Keith Lerner, co-chief investment officer at Truist Advisory Services.
The current ERP level has historically translated to just a 1.3 percent average 12-month excess return of the S&P 500 over the 10-year Treasury, according to Lerner.
The 10-year Treasury yield up to 4.5 percent “changes the narrative for stocks,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management, who is holding a higher-than-normal cash position.
“Investors are going to be even more worried that we could enter into a recession as the cost of borrowing is increasing and corporate margins will be squeezed,” he said.
Analysts at BofA Global Research argue that equities – specifically, the tech-heavy Nasdaq 100, which has soared 33 percent in 2023 in part due to excitement over advances in artificial intelligence – have until recently ignored the risk of rising rates. – Reuters
