Rising Bond Yields Change the Calculus for Stocks
Investors stung by deep losses this year face their next big test this week when the Federal Reserve holds its September meeting.
The setup could hardly look less desirable.
When interest rates were at rock bottom, as they were after the 2008 financial crisis and then again after the pandemic, it was easy for investors to justify putting money in the relatively risky stock market. The returns they would get from stocks would almost always beat what they could get from government bonds yielding close to nothing—leading Wall Street to declare “there is no alternative” to stocks.
That dynamic has been upended this year. After several Fed interest-rate increases, yields across the Treasurys market are trading at multiyear highs. Now, fewer than 16% of S&P 500 stocks have dividend yields greater than the yield of the two-year US Treasury note, which is approaching 4%. Fewer than 20% have dividend yields greater than the yield of the 10-year note, according to Strategas. Those numbers mark the lowest share since 2006.
“A lot of investors chose to take risk in the equity market because there was no return available anywhere else. Now’s the time where people are thinking, ‘Do I really need to take that risk?’ said Katie Nixon, chief investment officer of Northern Trust Wealth Management.
US stocks have fallen four of the past five weeks, with the Dow Jones Industrial Average last week suffering one of its worst pullbacks of the year. The blue-chip index has fallen 15% in 2022, while the S&P 500 is down 19%.
Whether or not markets get any reprieve depends in part on what happens at the end of the Fed’s policy meeting Wednesday.
Traders see an interest-rate increase as a foregone conclusion. Federal-funds futures tracked by CME Group show the market assigning a 100% probability of the Fed raising interest rates by at least three-quarters of a percentage point.
What’s less certain, investors say, is what Fed Chair Jerome Powell will say at the central bank’s postmeeting press conference. Markets swooned last month after Mr. Powell said the central bank would keep raising interest rates until it felt confident it had reined in inflation, even if that wound up hurting the economy. Investors who have largely tossed aside hopes for a Fed pivot are now anxious for clarity on two things: how high interest rates will go by the end of the rate-increase campaign, and for how long they will stay there.
“The Fed statement will be everything,” said Louis Navellier, chief investment officer of Navellier & Associates. “We need a light at the end of the tunnel.”
Mr. Navellier estimates he has put 60% of his portfolio into the energy sector this year. That is a choice that has paid off, given stubbornly strong inflationary pressures have made energy stocks by far the best-performing S&P 500 sector this year.
“All I care about is finding the silver lining window. But that window is getting much more narrow,” Mr. Navellier said, adding that it has become more difficult to pick winning stocks.
So far, data haven’t been on investors’ side.
Money managers had gotten a glimmer of hope last month when the Labor Department’s consumer-price index report showed inflation pulled back slightly from multidecade highs in July. But the department’s most recent report, released last week, failed to show that trend continuing. Core CPI, which excludes volatile food and energy prices, rose 0.6% in August from the month prior, double July’s pace.
“In my view, that starts the clock over,” said Brad Conger, deputy chief investment officer of Hirtle Callaghan & Co., referring to the Fed’s desire to see data over multiple months before deciding that inflation is subsidizing enough for it to slow down its pace of rate increases. “For equity investors, that’s a really challenging backdrop,” he added.
Meanwhile, the Fed’s interest-rate increases also threaten to put more pressure on an already slowing economy. Last week, mortgage rates jumped above 6% for the first time since the 2008 financial crisis. Rising borrowing costs have led to declining sales of existing homes for six straight months.
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Consumers’ spending on other areas, including clothes, food and big-ticket items like cars, has remained strong. Corporate earnings have also proven to be better than feared, even with companies being hit by higher costs for everything from freight to raw materials to wages, and the labor market has continued to be a bright spot for the economy.
Yet investors say they can’t help but wonder how long those trends will last, especially since the Fed doesn’t look anywhere close to done with its rate increases.
Bond traders are currently pricing in a terminal rate—the peak federal-funds rate in a rate-increase cycle—of around 4.41% in April, according to FactSet.
Some economists see the Fed taking the terminal rate even higher. Nomura economists are forecasting a terminal rate of 4.5% to 4.75%, up half a percentage point from their prior call. Deutsche Bank‘s
chief US economist sees the federal-funds rate going as high as 5%.
At this point, a lot of the bad news hanging over investors’ heads already seems to have been priced in by the markets, Ms. Nixon said.
But even with that in mind, it is difficult to see an easy path higher for markets, given the combination of tightening monetary policy, slowing growth both in the US and globally, and above-trend inflation, Ms. Nixon said.
“What’s the catalyst to propel markets higher? That’s where short term, things are still very murky,” she said.
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