Analysis-Positive real yields may spell more trouble for U.S. stocks

div classBodysc17zpet90 cdBBJodivpBy Lewis Krauskopfp

pNEW YORK Reuters – A hawkish turn by the Federal Reserve is eroding a key support for U.S. stocks, as real yields climb into positive territory for the first time in two years.pdivdivdiv classBodysc17zpet90 cdBBJodiv

pYields on the 10year Treasury InflationProtected Securities TIPS – also known as real yields because they subtract projected inflation from the nominal yield on Treasury securities – had been in negative territory since March 2020, when the Federal Reserve slashed interest rates to near zero. That changed on Tuesday, when real yields ticked above zero.p

pNegative real yields have meant that an investor would have lost money on an annualized basis when buying a 10year Treasury note, adjusted for inflation. That dynamic has helped divert money from U.S. government bonds and into a broad spectrum of comparatively riskier assets, including stocks, helping the S&P 500 more than double from its postpandemic low.p

pAnticipation of tighter monetary policy, however, is pushing yields higher and may dent the luster of stocks in comparison to Treasuries, which are viewed as much less risky since they are backed by the U.S. government. Graphic: Real yields turn positive, https:graphics.reuters.comUSASTOCKSYIELDSxmvjoyogqprchart.png p

pOn Tuesday, stocks shrugged off the rise in yields, with the S&P 500 ending up 1.6 on the day. Still, the S&P 500 is down 6.4 this year, while the yield on the 10year TIPS has climbed more than 100 basis points. p

p“Real 10year yields are the riskfree alternative to owning stocks,” said Barry Bannister, chief equity strategist at Stifel. “As real yield rises, at the margin it makes stocks less attractive.”p

pOne key factor influenced by yields is the equity risk premium, which measures how much investors expect to be compensated for owning stocks over government bonds. p

pRising yields have helped result in the measure standing at its lowest level since 2010, Truist Advisory Services said in a note last week.p

pGraphic: Equity risk premium shrinking, https:graphics.reuters.comUSASTOCKSREALYIELDSznvneqyljplchart.png HEADWIND TO GROWTH SHARESp

pHigher yields in particular dull the allure of companies in technology and other highgrowth sectors, with those companies cash flows often more weighted in the future and diminished when discounted at higher rates.p

pThat may be bad news for the broader market. The heavy presence of tech and other growth stocks in the S&P 500 means the indexs overall expected dividends are weighted in the future at close to their highest level ever, according to BofA Global Research. Five massive, highgrowth stocks, for example, now make up 22 of the weight of the S&P 500. p

pAt the same time, growth shares in recent years have been highly linked to the movement of real yields.p

pSince 2018, a ratio comparing the performance of the Russell 1000 growth index to its counterpart for value stocks – whose cash flows are more nearterm – has had a negative 96 correlation with 10year real rates, meaning they tend to move in opposite directions from growth stocks, according to Ohsung Kwon, a U.S. equity strategist at BofA Global Research.p

pRising yields are “a bigger headwind to equities than they have been in history,” he said.p

pGraphic: Growth stocks growing share in S&P 500, https:fingfx.thomsonreuters.comgfxmktzgpomyqnlpdPasted20image201649962751839.png Bannister estimates the S&P 500 could retest its lows of the year, which included a drop in March of 13 from the indexs record high, should the yield on the 10year TIPS rise to 0.75 and the earnings outlook – a key component of the risk premium – remain unchanged.p

pLofty valuations also make stocks vulnerable if yields continue rising. Though the tumble in stocks has moderated valuations this year, the S&P 500 still trades at about 19 times forward earnings estimates, compared with a longterm average of 15.5, according to Refinitiv Datastream.p

p“Valuations arent great on stocks right now. That means that capital may look at other alternatives to stocks as they become more competitive,” said Matthew Miskin, cochief investment strategist at John Hancock Investment Management.p

pStill, some investors believe stocks can survive just fine with rising real yields, for now. Real yields were mostly in positive territory over the past decade and ranged as high as 1.17 while the S&P 500 has climbed over 200.p

pJPMorgan strategists earlier this month estimated that equities could cope with 200 basis points of real yield increases. They advised clients maintain a large equity versus bond overweight.p

p“If bond yield rises continue, they could eventually become a problem for equities,” the banks strategists said. “But we believe current real bond yields at around zero are not high enough to materially challenge equities.”