The Tina trade – the idea that there is no alternative to stocks in a low-yielding world – has helped support the US bull market over the last nine years. Today, however, US interest rates are rising and 10-year bond yields have hit their highest level in seven years. Should equity investors be worried? The prospect of rising rates has unsettled stock markets. Strong economic data – US unemployment has fallen to just 3.7 per cent, its lowest level since 1969 – means the Federal Reserve is widely expected to increase rates for the fourth time this year in December.
Recent comments from Fed chairman Jerome Powell suggest 2019 will be little different. Current rates remain "accommodative", said Powell, but are moving to neutral levels – that is, neither accommodative or restrictive. "We may go past neutral," he added. "But we're a long way from neutral at this point, probably". US 10-year bond yields, which were as low as 1.36 per cent at their 2016 nadir and which rested at 2.4 per cent at the beginning of 2018, hit 3.25 per cent in the days following Powell's comments. Over the past three decades, only five years have recorded a larger increase at this stage of the year than that seen in 2018. This is not the first time in 2018 that investors have been unsettled by rapidly rising bond yields. Stocks suffered a double-digit percentage correction in February after yields spiked higher following data suggesting increased inflationary pressures and the likelihood of higher interest rates. Most non-US stock markets remain well shy of their January highs and even the S&P 500, the undisputed leader among international markets this year, needed over six months to reclaim its losses. There are obvious reasons why investors are wary. Firstly, widespread complaints in recent years that stocks looked expensive have often been dismissed on the grounds that in a zero-rate world, investors had little option but to take their chances in the stock market. With risk-free assets now yielding more than 3 per cent, stocks are finally facing competition and some investors may feel it's safer to pull back from riskier assets.
Secondly, higher rates slow economic growth by increasing the cost of borrowing for consumers and corporations. The late Federal Reserve chairman William McChesney Martin famously said the Fed’s job was to “take away the punch bowl just as the party gets going”, and many bull markets have been ended by rate hikes designed to quell animal spirits.
Positive returns
Still, bulls might retort, stocks have done just fine in recent years, even though bond yields have been rising since the summer of 2016 and the Fed has already hiked rates seven times in the current cycle. Indeed, historical research “doesn’t show a pattern of falling stock prices during rate-hiking cycles”, notes index fund giant
Vanguard
.
Hiking regimes often occur when the economy is strong and when earnings growth is robust, resulting in favourable stock market performance. Vanguard examined 11 periods of rising rates over the past 50 years; stock returns “were positive in all but one of them”, with annualised returns in line with historical averages.
Vanguard's take is echoed by Ben Carlson of Ritholtz Wealth Management, who analysed 17 previous instances where 10-year bond yields rose by amounts comparable to that seen since mid-2016. There were some instances where rising rates coincided with stock market peaks – in particular, rates were rising in the period prior to the 1987 stock market crash and prior to the popping of the technology bubble in 2000. Overall, however, the S&P 500 generated above-average returns during rising rate environments, Carlson found. Still, sceptics might argue that this time is different and that the unprecedented low-rate regime of the last decade has driven stock markets to dangerously elevated levels.
The S&P 500 now trades on a cyclically-adjusted price-earnings (Cape) ratio of 33. Only once, at the peak of the aforementioned dotcom bubble, when stock mania drove the Cape ratio as high as 44, has it ever exceeded current levels.
Critics of the Cape ratio say it needs to be adjusted downwards to account for lower corporation tax rates and changes in accounting standards. Still, most commentators agree that, after nine years of stock market gains, stocks are richly valued.
High valuations partly explain why stocks have edged rather than soared higher in 2018, despite a raft of supporting factors (for example, 25 per cent earnings growth, unemployment hitting a 49-year low, and record stock buybacks).
Tipping point?
High valuations might tempt some investors to park more of their money in risk-free assets that are finally offering respectable levels of income. Nevertheless, investors are divided as to the tipping point for stock markets.
It's far too early to worry about rising bond yields, according to Barclays, which says they are "not a problem for equities and should rather be welcomed" as evidence of sustained economic expansion. Merrill Lynch quantitative strategist Savita Subramanian is also nonplussed. She tested a number of levels to determine at what point 10-year bonds start to look more attractive than stocks and they "all spit out the same number: 5 per cent". Others are less sanguine, however. Credit Suisse analysis of the last half-century confirms that bond yields in the region of 5 per cent have typically marked the tipping point for stock markets, but the bank cautions that this time is different due to the high valuations occasioned by the easy money policies of the last decade.
Yields in excess of 3 per cent make stock valuations look challenging, says Credit Suisse, and pressures will become more marked if bond yields top 3.5 per cent. That’s echoed by recent monthly fund manager surveys conducted by Merrill Lynch; on average, fund managers believe that a 10-year bond yield of 3.6 per cent would spark a rotation from stocks into bonds.
A more middle-ground approach is stressed by analysts at Alliance Bernstein, which cautions that stocks “can struggle to digest” large changes in bond yields over short periods of time before adding that stocks are likely to fare well over the medium term so long as higher yields are being driven by renewed economic optimism. Confused? For most investors, the best option is to ignore the endless agonising, suggests Vanguard. Tilting toward stocks or bonds “would amount to trying to time the markets”, it says, “which research has shown time and again is a strategy that often doesn’t work out well”.
