SocGen has seen enough.
This is pretty straightforward, so I’ll just get right to the point: The bank says it’s time to lower your equity allocation and the rationale is simply that 10Y Treasury yields look to have pushed above 3% on a sustainable basis and that’s trouble under the circumstances.
Equities of course sold off hard in October and while weakness during the latter half of the month appeared to come courtesy of late-cycle jitters, ongoing de-risking from discretionary investors who saw legacy longs underperform handily and generalized angst around the prospect that Q3 marked “peak profits”, the initial systematic rout that unfolded on October 10 started with a sharp selloff in bonds the week before.
All year, market participants have fretted about the prospect of rising yields eventually denting equities and when the long end sold off during the first week of October following a blockbuster ADP print and an equally euphoric read on ISM services, the equity-rates correlation flipped positive, presaging diversification desperation.
Generally speaking, bonds failed to rally convincingly during the latter half of the month despite the ongoing turmoil in stocks. That prompted Goldman to suggest that “something’s got to give.”
That brings us to SocGen, and a note out Wednesday.
“The tax-cut boost to earnings helped the US equity market remain resilient in the early phase of rising bond yields, however, a UST yield of above 3% on a sustainable basis is now starting to impact US stocks”, the bank writes, adding that “with the US equity risk premium already well below its long-term average, any rise in volatility would mean further deterioration in the equity risk-adjusted return.”
The bank goes on to present a sensitivity analysis using different ERPs and levels on 10Y yields to show the various possible combinations and outcomes.
The bottom line, from where SocGen is sitting anyway, is this:
If the absolute valuation (measured by cost of equity) as well as relative valuation (equity risk premium) of equity is rich, the ability of equities to absorb higher bond yield is rather limited. To maintain the same valuation relative to government bonds, the US equity market needs to adjust lower to absorb the higher bond yields.
Assuming an ERP at 3% and 10Y yields at 3.25%, the S&P “needs” to fall to 2,482. Obviously, it gets worse from there, where that means higher yields equal lower equity prices.
You can take all of that for what it’s worth. Ultimately, this is just a straightforward way to think about things in an environment where 10Y yields look poised to remain elevated.