Morgan Stanley’s Mike Wilson and Goldman’s David Kostin agree: Elevated rates are now an impediment to multiples and could cap, or at least restrain, equity upside in the near-term. (Groundbreaking stuff, I know.)
Wilson’s been adamant that 4.40% on the US 10-year is a pain threshold of sorts for stocks — that beyond that level, equities will generally exhibit more rate sensitivity. That’s been correct. Stocks did indeed stumble beginning in early April as yields broke decisively above the range Wilson flagged as potentially perilous.
Multiples contracted sharply into a three-week mini-selloff and Wilson, who sat out the first part of a historic five-month rally, finally got a win. Stocks rebounded sharply last week, though, erasing more than half of a 5% pullback. On Monday, in his latest, Wilson underscored the notion that the “pros” are indeed a bit confounded by pervasive ambiguity.
The macro-policy environment is “unpredictable and volatile,” he wrote, and likely to stay that way, even as equity valuations “seem to be suggesting a level of stability and predictability.” That, he warned, “may be unrealistic.”
The figure below shows Morgan Stanley’s scenario analysis for the US economy. It’s not — and I’ll be generous — especially differentiated.
If I never see another aeronautics metaphor after this cycle I’ll die a happy man.
Wilson thinks “no landing” is the most likely outcome and given that, he’s still focused on benchmark US yields. “The level and six-month rate of change on the 10-year Treasury yield remain key determinants of near-term equity price action,” he wrote.
As ever (and regular readers have heard this from me countless times over the years), it’s about the rapidity of a given move in yields, not necessarily the level. In his last several notes, Wilson focused on a simple regression using the six-month rate of change. He revisited that on Monday.
“Over the next eight weeks, the comparisons on yields get easier given the precipitous fall in the 10-year yield in November and December,” he wrote. “Should rates remain at current levels, one could expect ~7% downside to price/earnings multiples over the next eight weeks, all else equal [while] a linear rise to 5% on the 10-year by the middle of July would imply ~11% downside to multiples during that period.”
Notably, that logic suggests equity multiples could contract even in a sharp bond rally: Wilson’s using a six-month rate of change, and 10s were 3.80% in late December. They’re 4.75% now. If you go by Wilson’s regression, a rally to 4.25% (not a trivial move by any stretch) “could still imply modest downside to multiples.”
I take Wilson’s point, but I think he’s overthinking this. If rates (and particularly reals) rise really far, really fast (if readers will forgive the lapse into a colloquial cadence), equities will struggle. And vice versa. Period. You don’t need a lot of math.
In his latest, David Kostin dusted off Goldman’s rule of thumb. “Since 2006, the S&P 500 has fallen by an average of 4% when real yields rose by more than two standard deviations in a month,” he wrote.
I’ve always liked the figure above. It’s straightforward: A big jump in reals undercuts equities via multiple compression, while very large declines in yields are likewise associated with equity pullbacks, typically because if nominal yields are plunging, something’s gone wrong.
“Today, a two standard deviation one-month increase in the real 10-year yield equals roughly 55bps,” Kostin wrote, adding that the 4% pullback in US equities from mid-March is “in line with the historical playbook,” given that reals are up 40bps over the same period.
Of course, a lot depends on why yields are rising, but that nuance is lost on stocks past a certain point. As Kostin put it, “equities will struggle to find their footing if rates continue to rise sharply, regardless of the macro driver.”
Wilson reiterated that “the economic and policy environment” are likely to remain fraught. “That, combined with the headwind from the six-month rate of change on the 10-year yield suggests P/E multiples may face pressure over the near-term,” he added.
if the 10-year minus 2-year curve reverts to positive territory, and inflation dips just a hair below 3%, and markets do not suffer a huge loss, and employment and GDP remain positive, does that count as any sort of landing? Something in between scenario #1 and scenario #2 perhaps? I mean, other than a complete victory, do we actually expect Powell to ever declare that we have officially landed?
Reacting to this as well as the Kolanovic piece, I’m amazed how little attention strategists are, at least publicly, giving to what we can expect if/when Trump returns to the White House. The same holds for most of our group of frequent commenters.
There seems to be insouciance rather than indifference. With reasons such as:
1) the election is still six months away. We’ll focus when things get clearer.
2) If he comes back, it would be just like last time when “the adults in the room” thwarted Trumps wilder economic ideas.
#1 may prove wise. For traders and short-horizon speculators. But then, we love to label stocks as being long duration assets. Shouldn’t our thinking match that?
#2 is dangerously wrong. There will be no tempering advisors or cabinet members. The screening of possible hires is underway and, surprisingly, loyalty to Trump is the primary requirement.
A scary thing about #2 is that Trumps’s senior advisors-in-waiting are the authors of their plans to slap on widespread tariffs, deliberately try to weaken the dollar and assert increased presidential authority over the Fed. Oh, and don’t forget Stepen Miller’s mass deportation plan. Those are the “adults in the room.”
Most scary is that, outside of the Fed thing, these don’t appear to be trial balloons. For example, Miller has stated that they not only have the plans ready to go on “day one”, they also have pre-prepared legal filings around the country to see off challenges.
But short-term vol is falling back so sit back and enjoy the flight.
Just a guess, Derek, but if there is going to be a market reaction to a potential 2nd Trump term, barring any unforeseen event such as a health scare for Biden, I’d expect it in Sep or early October. Until then I think the perception is going to be that it’s too early to react and possibly be in the wrong side if the politics change as the home stretch gets nearer.
I’m curious how others here view the potential reaction. Many market participants may feel likelier tax cuts, and potentially more inflationary policies may counteract the potential negative consequences.
I started as a trader in the late 1970s, the era of stagflation. I haven’t really had to recall all that I learned back then (often the hard way) thanks to Volcker followed by the deflationary impact of in Mexico and China entering the global economy.
But when I see the push to decouple from China and read Trump’s plans, I see a surefire recipe for a similar bout of stagflation.
I imagine Wall Street analysts/strategists have business reasons to tread lightly on politically tricky topics.
What will be the best investment move if Trump wins?
I’m thinking a pied-a-terre in a foreign country.
+1. If you happen to look black, Latin or Asian I’d be most concerned about what the newly-empowered Magalytes will take into their own hands. Along with potential dollar weakness eroding our purchasing power.
Thanks John,
My wife happens to think you’re a genius!