(Bloomberg) — The steepest bond selloff in history, Europe’s first land war between two sovereign states since 1945, a Federal Reserve tightening into a possible growth slowdown. Oh, and U.S. inflation still near a four-decade high.
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For all the threats out there, stocks this week were barely feeling the fear as developed world markets rallied back to levels seen before Russia’s invasion of Ukraine a month ago. That’s even as Treasury yields broke out anew and key sections of the bond curve signaled economic trouble.
As the Fed embarks on an aggressive path of policy tightening, it looks like something may have to give. Strategists at Mizuho International Plc are among those warning risk assets — and eventually economic growth — won’t be able to resist the heavy pull of a higher discount rate.
Yet a growing number of money managers are betting equity indexes have already largely priced in bearish bond moves, while all signs suggest the U.S. economy remains in decent health.
“Judging from the performance of risk assets, markets seems to believe such levels will not trigger a recession and hurt risk assets,” said Janet Mui, head of market analysis at Brewin Dolphin Ltd. “I think there is a degree of complacency there.”
Real yields, a key driver for cross-asset valuations, point to the growing dissonance. These inflation-adjusted yields are rising, a reason in theory for investors to pare exposures to richly valued high-growth equities whose profit potential lies in the future. Yet the opposite is happening.
The Wells Fargo basket of software-heavy stocks has rallied almost 20% since March 16, the start of the Fed’s rate-hiking cycle. That’s as benchmark U.S. real yields have surged toward a level that sparked a selloff in January.
Wall Street investors may be desensitized to the latest Treasury machinations this time round, while healthy earnings-growth expectations suggest a buoyant economy.
“Investors are now looking more to a future where real yields are higher, nominal yields are higher, but not so much that it is worth selling more equities at these levels,” said Luke Hickmore, investment director at abrdn.
Technical factors may be playing a role. According to JPMorgan Chase & Co. strategists, pension and sovereign wealth funds have already deployed as much as $230 billion to stocks to meet allocation targets. Now that those moves have played out, strategist Nikolaos Panigirtzoglou says equities look vulnerable.
“The rebalancing flows away from bonds into equities likely supported equities and hurt bonds over the past two weeks. Now that there is no much of pending rebalancing flow,” he said. “Equities would look more vulnerable from here if bond yields continued to rise.”
For Peter Chatwell, head of multi-asset strategy at Mizuho, it’s only a matter of time before the rate-sensitive investing styles reprice.
“We think the 2.75% rate will be highly restrictive for the U.S. and equally importantly for the global economy,” Chatwell said, referring to the Fed’s projection for the benchmark rate in late 2023. “Slowly but surely, risk premia will rise and earnings expectations should moderate.”
Strategists at both Goldman and Bank of America Corp. see a terminal rate of around 3% and 3.25% — something that could hit risk valuations in its wake.
Mui, for one, sees a pain threshold for markets if the 10-year U.S. yield reaches 3%.
“The risk of recession is still low, but it is building as we head to 2023,” Mui said. A break higher to 3% would make investors reconsider, and start to prepare for “a recession or more protracted slowdown,” she said.
For companies of all stripes, higher yields tend to reduce the present value of future earnings streams, other things being equal. Rising borrowing costs also hurt those carrying the highest leverage, potentially undercutting economic activity.
“Now rates volatility can drive growth volatility and that actually becomes a vicious cycle between the two,” said Christian Mueller-Glissmann, managing director of portfolio strategy and asset allocation at Goldman Sachs Group Inc. “That’s a big difference to the last cycle where growth volatility drove rates volatility.”
For now, the stampede into risk assets continues. Inflows into stocks have been outpacing those into bonds eight-to-one so far this year, exchange-traded fund data compiled by Bloomberg Intelligence show.
“Ultimately, it seems likely there will need to be a slowdown in growth and fear around possible recession before yields stop rising and equities come under more pressure,” said Mark Dowding, chief investment officer at BlueBay Asset Management. “It will be hard to pinpoint when it will happen.”
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