(Bloomberg) — Volatility in the world’s biggest bond market has finally caught the attention of investors on Wall Street who’ve been plunging into stocks all year.
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A Treasury rout that pushed 10-year yields close to the highest since 2007 has spurred what is now the biggest break in an $8 trillion equity rally that had sent the Nasdaq 100 up as much as 45% in 2023. Major US benchmarks just slid in a third straight week for the first time since December.
While debate rages over why the bond market has turned dangerous again right now — inflation, Federal Reserve policy and the growth outlook are all in the mix — the issue for equity investors is less abstract. Rising risk-free payouts are getting too rich for many to turn down, particularly compared with expected returns in loftily priced stocks.
One metric in particular tells the story, a valuation lens known variously as the Fed model or equity risk premium. It shows the profit yield on S&P 500 shares — a rough proxy for return prospects that is the reciprocal of the price-earnings ratio — falling to its lowest level versus bond yields in nearly two decades.
That’s chasing a growing number of investors away from shares. One is Ulrich Urbahn, Berenberg’s head of multi-asset strategy, who has been buying fixed income to lock in high yields while gradually decreasing equity exposure.
“Given rising real yields and ambitious valuation levels in particular for US stocks, we think that the risk-reward looks better for bonds,” said Urbahn, who has been increasing his flexible fund’s allocation to fixed income to 50% from 30%.
Of course, the question of what’s bugging the bond market is also relevant to share investors, who were counting on a soft landing in the economy to justify their exuberance. Most straightforwardly, it’s concern that Jerome Powell’s Federal Reserve will keep pushing up rates to fight inflation. Minutes from July’s Fed meeting released this week showed policymakers are a little more worried about price pressures than investors may have thought. At the same time, rising bond rates can also been seen as constructive bets on strengthening growth — a positive for stocks.
Whatever they portend, lots of people see rates going higher. Bank of America Corp. warned in a note of a “5% world,” echoing comments from Pimco founder Bill Gross and former Treasury Secretary Larry Summers, who estimate the 10-year could advance to 4.5% and 4.75% respectively.
The S&P 500 Index fell below its average price over the last 50 days on Tuesday for the first time in more than three months, while global bond yields reached their highest levels in 15 years this week. Investor sentiment also took a hit on news of China’s property crisis and troubles in its shadow banking system.
As stocks and bonds sold off in lockstep, the Cboe Volatility Index, jumped to roughly 18 on Thursday, its highest level since May, shrinking the gap with the bond volatility index. The ratio of the ICE BofA MOVE index — which measures expected price swings in US government debt — to the VIX narrowed to the smallest since March.
“We are seeing signs that equity investors are recognizing the outlook is not as sanguine as markets previously believed,” said Michael O’Rourke, chief market strategist at JonesTrading. “A further selloff in bonds should foster a larger equity correction as investor should demand a larger risk premium to own equities.”
Relative to its price, the S&P 500 “pays out” around 4.7% in earnings, versus roughly 4.2% on the benchmark US bond. The risk premium relative to investment grade bonds is even slimmer with the Bloomberg USAgg Index yielding around 5.1%.
Even for some of the biggest bulls on Wall Street including Ed Yardeni, the longtime stock strategist and founder of his namesake research firm, relative valuations may prove an issue for stock faithful.
“Stocks are less attractive after the big rally since October 12 and the run-up in bond yields.” Yardeni said. “That’s why we didn’t raise our year-end target of 4,600 when we got there ahead of schedule at the end of July.”
A worsening valuation calculus for equities may also be impacting flows.
Equity buyers went on strike this week with stock funds seeing outflows of $2.1 billion and breaking a three-week inflow streak, according to Bank of America Corp. citing data from EPFR Global. At the same time, Treasuries saw $3.9 billion of inflows in the week through Wednesday. Investors also flocked to money market funds with year-to-date cash inflows reaching $925 billion as of this week.
Still, making big bets on bonds hasn’t been a winning strategy in 2023, with the current selloff wiping out the annual gain in Treasuries. For John Roe, the head of multi-asset funds at Legal & General, which manages $1.4 trillion, the run-up in yields has further to go. The asset manager is already overweight long-duration bonds and underweight equities — and is now looking to add more fixed income exposure as soon as next week if the momentum holds.
“We don’t think there’s an obvious anchor for how high nominal yields can go,” Roe said. “After all just 18 months ago the current situation would have been seen as implausible by most of the market.”
–With assistance from Cecile Gutscher and Isabelle Lee.
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