Last week, in “Too Hot,” I insisted on the idea that the trek higher for US real yields is unfriendly to an equity rally built on multiple expansion among richly-valued, long-duration growth shares.

Generally speaking, rising reals can be conceptualized as kryptonite, or gravity, for high-flying stocks untethered from the fundamentals. And rates are anyway a fundamental input.

For all the attention paid to America’s “Magnificent 7” (which together added the market cap equivalent of the German economy in the first half), the median P/E is nearly as rich as the aggregate index multiple in the US. In other words: The market has re-rated in 2023 fairly aggressively irrespective of how you look at it, and despite stubbornly elevated reals.

Last week, though, equities responded to the selloff in bonds and on Monday, Morgan Stanley’s Mike Wilson weighed in, calling the action in rates “the most significant macro development.” Rising yields triggered a reaction in equities which, while “fleeting,” was nevertheless notable “in that it was the first time in several months that equities appeared to be adversely impacted by a move higher in real yields,” Wilson wrote.

The figure above illustrates the point. It was most visible in the wake of the scorching read on private sector hiring from ADP. Wilson mentioned that session specifically.

To some, this hints at a new rates shock and a possible return to the “nowhere to hide” dynamic that prevailed in 2022, among the worst years on record for a simple, balanced stock-bond portfolio.

“If real rates push higher, could we return to a backdrop where equity returns are adversely impacted as a result?” Wilson wondered, before calling such an outcome “feasible.”

Morgan Stanley pointed to the renewal of a negative correlation between real rates and stock returns. That relationship was negative for most of 2022, as tighter financial conditions, exemplified by reals, weighed on equities.

Relatedly, any renewed volatility in rates would be a decidedly unwelcome development for stocks. I’ve been over this time and again. The Fed is plainly nearer the end of the tightening cycle than the beginning (unless you think terminal is in the double-digits), but the dots hint at scope for additional fireworks, and there’s virtually no visibility around the appropriate level for yields further out the curve.

On that latter point, I’ll recycle some language from last week. Voter demands on fiscal policy will probably increase going forward. The likelihood of developed market electorates accepting austerity or any sort of “belt-tightening” is low given seismic shifts in the socioeconomic backdrop. Rearmament will likewise demand more federal spending, re-shoring is inflationary and so on. With some of the structural enablers that helped keep inflation low over the past three decades lost to the pandemic and the war, it’s possible that macro volatility will remain elevated in perpetuity, which makes forming consensus about the “appropriate” level of bond yields very difficult.

Wilson touched on those points, some directly, some tangentially. “With the Fed seemingly getting more hawkish and the rate path more uncertain, rate vol has begun to pick up again,” he said.

The charts above show that valuations can be “sensitive” to rates vol, but here again we see stocks (or in this case multiples) diverging.

Disentangling the signal from rising reals is sometimes difficult given that firmer long-term growth expectations should naturally translate into higher rates. That makes it hard to say whether equities are “rightly” anticipating a better economic outlook or whistling past a graveyard where the epitaphs are forlorn odes to things broken during past Fed tightening cycles.

At the least, we can say there are friendlier environments for stocks than the current conjuncture, which juxtaposes elevated multiples and an earnings recession with a Fed that’s still raising rates. Of course, profit growth may be poised to inflect for the better, and the market doesn’t assign a trough multiple to trough earnings, but there are a lot of implied “ifs” there.

Wilson summed it up. “Bottom line, tightening liquidity conditions and higher rate uncertainty/volatility should lead to lower equity valuations unless earnings season provides hard evidence of the big re-acceleration in growth that is now priced into stocks,” he said.