Only One Thing Matters Now

Maybe it’s time for stock replacement strategies.

That was one takeaway from two-dozen pages penned by Goldman’s Christian Mueller-Glissmann and Cecilia Mariotti, who cautioned that although stocks typically do ok with higher bond yields, “there can be temporary indigestion depend[ing] on the level of rates, the speed of the increase and the source of the move.”

This really is the only discussion that matters right now. In the simplest possible terms: If real yields keep rising and the incoming data continues to suggest the US economy is faltering, risk assets are likely to have trouble.

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The situation is especially problematic for US shares given elevated multiples and a ton of embedded duration risk. “With longer equity duration and potential for more volatility, at least temporarily, we like longer-dated call options to manage and maintain equity overweight allocations,” Mueller-Glissmann remarked, in the same note.

Admittedly, some of this is becoming repetitive, but that’s what happens when a single issue hijacks the narrative. The figure on the left (below, from Goldman), shows US equities tend to fall when rates rise more than two standard deviations over a one-month period. A one standard deviation move in reals is 16bps. The most recent surge was around three times that large.

Goldman also touched on a favorite talking point of mine — namely, the notion that the pain threshold for stocks when it comes to digesting rate rise is falling over time.

“Current levels of bond yields are still very low in a long-run context and historically US 10-year yields were above 4-5% when equity/bond correlations were positive on a sustained basis,” the bank went on to say, before immediately conceding that “this threshold may have declined since the 1990s due to weaker nominal trend growth globally, higher leverage in most economies and higher equity valuations.”

Obviously, deeply negative real yields were a factor in equities’ historic surge from the pandemic lows to recent all-time highs. As PIMCO CIO Dan Ivascyn put it in remarks to Bloomberg this week, “asset valuations are elevated across the board and that has been due to a low real yield regime.”

The figure on the right (above) is a bit noisy, but it gets the point across. And just in case it didn’t, Goldman’s Mueller-Glissmann elaborated. “Since 2020, the S&P 500 has been very correlated with US 10-year breakevens and negatively with US 10-year TIPS yields — as the rise in inflation expectations since last year has come alongside mostly anchored nominal and falling real yields, it was supportive of risky assets,” he said, before striking a cautionary tone. “Without continued strong growth, rising yields could weigh more on valuations of risky assets due to a repricing of inflation risk, and trigger growth fears due to monetary policy tightening.” The two figures (below) are straightforward.

Although Goldman expects global growth to be “well above-trend” in the first half of 2022, they see below-consensus growth in the US in the back half of the year due mostly to a waning fiscal impulse. That, Mueller-Glissmann suggested, could “worsen the mix of growth and real yields materially.”

Commenting further for the same linked Bloomberg article, Ivascyn summed it up. “Real yields are much more important than they have been in the past,” he said.

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7 thoughts on “Only One Thing Matters Now

    1. Or, we get a serious selloff and much lower inflation in 1H — not hard to imagine or do, given all the leverage out there — setting us up for a nice rebound in the data going into the midterms. Fingers crossed.

  1. H-Man, it appears sentiment is now running the markets and sentiment wants some good news but there is no “good” news anywhere you look. Inflation, Hiring, Back-logs, Russia, and the most important news, rates are rising. Sentiment may be negative for some time to come.

    1. There is good news. Covid is transitioning from pandemic to endemic- and the world is reopening. Supply chains have to get retooled- this takes time and money, but it is happening and the retooled supply chains will be less prone to breaking down when the inevitable kink occurs in the chain.
      Putin is Putin and Germany wants natural gas more than they want to defend the Ukrainians. Next.
      On lesser, but very important news, Biden is extending work visas for foreign students after they graduate from a US university from one to three years. Hopefully, we just give them a path to citizenship. Younger generations are well equipped to embrace the “melting pot” of the US. I am young at heart and I not only welcome hard working people from other cultures- I hope they bring their culture, food and art to America. This isn’t going to happen overnight- but it will happen. The US will grow the pie with intelligent immigration.
      So I can wait in cash, bonds, equities or rental real estate. I am leaving crypto to H- altho I am interested in Defi (I first became intrigued listening to Chamath). I am most comfortable in equities and a few real estate properties in resort type areas that I rent out when not using. I am not a trader. Any other ideas?

      1. I hope you are right about the new visa rules. For some years now roughly half the doctoral students, medical students, and other highly skilled, highly intelligent individuals in US universities are non-native and if we don’t keep them in the US after graduation we lose the ability to gain from those educations. Our medical, scientific, and engineering research and knowledge as a nation depend on these folks. If we can’t keep them they will be selling what they have learned to our competitors.

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