Morgan Stanley’s Mike Wilson, who’s generally bullish on equities headed into 2021, says stocks may be ripe for a correction.
“The market is overbought and probably a little bit overvalued quite frankly because interest rates are finally now starting to catch up,” he told Bloomberg TV. “The risk in the market now is that as 10-year yields finally start catching up, we have a valuation reset because stocks are a long duration asset, particularly the US stock market.”
This week’s backup in long-end Treasury yields has some folks concerned. In addition to posing a risk to equities trading at some of the richest multiples since the dot-com bubble, higher yields could tighten financial conditions just as surging virus caseloads, record COVID-19 fatalities in the US, and new restrictions on activity and mobility, together cast a pall over upbeat vaccine news. 10-year yields were up ~11bps on the week through Thursday morning. The 2s10s is the steepest in three years.
The S&P 500 is obviously heavily skewed towards a handful of secular growth favorites and the worry is always the same in that regard: A shift in the macro regime to higher yields and bear steepening could undercut perennial winners in equities to the detriment of indexes that, on some days, live and die by moves in familiar, household names.
More generally, I’d just repeat what I wrote here on Wednesday in a pre-dawn note:
So, we’re now back to asking whether rising yields are good or bad for risk assets, and the answer is always the same: It depends.
Higher breakevens against a backdrop where disinflation beckons at every turn are a welcome development and a referendum on the Fed’s success. But, as ever, some will fret that past a certain point, the good, reflationary vibes and any mechanical, downward pressure on real rates, will be overwhelmed in the “eyes” of stocks by a “too” high level for nominals.
That’s the whole debate encapsulated in just a few sentences. (And readers should applaud me for that, because brevity isn’t really my strong suit.)
“We were encouraged to see the breakout in 10-year breakevens,” BMO’s US rates team said Thursday, noting that the last time 10-year BKEs were at current levels, “the degree of economic optimism and reflationary ambitions were an order of magnitude above the current levels.”
If you think back to May of 2019 (when breakevens were last at 1.85), that was the month the Trump administration broke the Buenos Aires trade truce and blackballed Huawei, cranking up the pressure on Beijing. By August of 2019, the world was in full-on, growth scare mode after Trump abandoned the Osaka truce, leading to a mammoth bond rally (accelerated by a convexity flow pile-on) which inverted the 2s10s.
“Unlike the nominal market, which has the overhang of potential QE WAM extension later this month, inflation expectations will only be stoked further by a fresh round of monetary policy accommodation,” BMO’s Ian Lyngen went on to write Thursday. “This is consistent with the prevailing logic that once the economy is functioning anywhere close to normal, the excess liquidity already in the system will drive demand and therefore prices.”
That’s a crucial point. If the Fed moves ahead with WAM extension at this month’s meeting, it could put a lid on yields, thereby limiting the scope for rate rise to imperil the equity rally, while simultaneously engendering more positive, reflationary vibes. The figure (below) is critical when it comes to understanding the stock-bond interplay over the course of the post-March equity rally.
As long as real yields stay deeply negative, it’s somewhat difficult to imagine risk assets getting overly concerned. US financial conditions, you’re reminded, are the easiest in history.
If the Fed can keep a lid on nominal yields and sub-zero reals continue to put pressure on the dollar, that’s a risk-positive backdrop. That’s not to say that stocks trading at dot-com multiples can’t selloff. They clearly can. It’s just that I find it difficult to believe that 1% on the US 10-year would be the catalyst for some kind of epic meltdown. Remember: When rate rise tipped US equities into a painful correction in the fourth quarter of 2018, real yields were >1%. Now we’re asking if nominals above 1% are bad news.