Despite a strong year-to-date rally, the stock market is facing a hurdle with rising Treasury yields. As August progresses, all major indexes are currently in the red for the month. This has raised concerns among strategists about what can propel stocks higher, ranging from renewed interest in technology like artificial intelligence to corporate earnings.
According to Tom Essaye, founder of Sevens Reports, a decline in Treasury yields could provide a much-needed boost to the markets. However, he emphasizes that yields represent more than just concerns about ongoing interest rate hikes by the Federal Reserve.
Many economists expect the central bank to raise interest rates at least once more before considering any potential cuts next year. The general expectation is that rates will remain elevated for a longer period to combat inflation, which continues to exceed the Fed’s targeted 2%. Consequently, this anticipation drives up the yield on Treasuries, with the yield on the 10-year T-note reaching its highest level this year on Tuesday.
Higher interest rates pose an obvious problem for numerous companies as they increase the cost of capital. This means it becomes more burdensome for these companies to borrow funds necessary for profit-generating expansions. As a result, the stock prices of companies that rely on consistent or substantial levels of cash are often affected.
However, Essaye points out that higher yields also impede the overall market as they diminish the premium investors demand for investing in what is inherently a riskier asset. Essaye calculates the equity risk premium as follows: the S&P 500 is currently trading at 18.68 times expected 2024 earnings per share. Taking the inverse of this number – 1/18.68 – yields 5.3%. Essentially, this is the return investors expect from stocks over the next year.
The problem arises when investors consider that 10-year Treasuries presently offer a yield of 4.23%. Why should investors take on the extra risk of investing in stocks for just a marginal 1% increase in returns? In other words, a guaranteed 4.23% return is more appealing than a potential 5.3% return from stocks.
In conclusion, as Treasury yields continue to rise, they present a significant challenge for the stock market. The increasing cost of capital and the reduced premium for investing in stocks create obstacles that need to be addressed for the market to regain momentum.
The Challenge of Low Equity Risk Premium
The equity risk premium is a key indicator that investors consider when evaluating the attractiveness of stocks compared to other asset classes. Currently, the equity risk premium stands at a mere 1%, considerably lower than its historical average of 4%. This meager figure has raised concerns among market commentators.
Furthermore, bonds are emerging as a more competitive alternative to stocks. Charles Schwab Chief Investment Strategist Kevin Gordon emphasizes the increasing attractiveness of the bond market, especially as stock valuations continue to rise. The higher yields on bonds level the playing field for both asset classes and pique the interest of yield-hungry investors.
To boost the market’s risk premium, the S&P 500’s valuation would need to decline, creating a more enticing entry point for investors. However, this poses a challenge as long as Treasury yields remain elevated due to the Federal Reserve’s interest rate campaign.
The problem lies in the fact that rising Treasury yields prompt investors to rotate out of riskier equities and into safer bonds. The potential additional return from stocks fails to outweigh the accompanying volatility. Essaye argues that while achieving the historical 4% risk premium seems unlikely in the current environment, a “fair” number for 2023 should definitely surpass the paltry 1% we see now.
There is a possibility for Treasury yields to decrease if the Fed adopts a more dovish stance or if there is consistent evidence of cooling inflation. On the flip side, if the 10-year yield continues to climb and remains high, stocks will face significant valuation headwinds not seen in years, if not decades. This does not necessarily imply an imminent market downturn, but it certainly diminishes the likelihood of the ongoing rally extending further without a decline in yields.
In conclusion, the challenge of a low equity risk premium demands careful consideration from investors. The allure of bonds as an alternative asset class and the potential implications of rising Treasury yields highlight the need for a proactive approach to navigate the markets effectively.