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How bond yields reflect strong economic growth

Ernesto Ramos, CIO of BMO Global Asset Management joins Yahoo Finance to discuss the push in bond yields, outlook in valuations, and the corporate tax rate hike.

Video Transcript

- Talk more about all this, let's bring in our Ernesto Ramos. He is the CIO of BMO Global Asset Management. Ernesto, thank you for being here. So I do want to get your take on what we're seeing in the bond market and the interplay between bonds and stocks here this morning. How concerned are you about the push up in bond yields and do you feel like we are seeing any kind of sustainable threat to the big rally we've seen in stocks?

ERNESTO RAMOS: Well interestingly, I think the push up in bond yields is overdue. Because we have the prospect of very strong economic growth in the US. You have seen other indicators of economic activity be very strong. For example, commodities have been on a real tear since last summer. Bond yields are reflecting stronger economic growth. Some people are estimating, or the consensus is estimating maybe 6% to 7% growth for 2021. You see the roll out of the vaccine be very-- improving a lot and really starting to hit and make a difference. So a lot of signs of reopening are there, and the economic growth will reflect that and therefore bond yields have to reflect stronger economic growth. And that's why they've moved up. They've moved up pretty quickly. But they've really started moving up since July from 60 basis points all the way up to where we are today at 135 or whatever it is, at this minute.

- We saw the opening bell there on this Monday morning as we get the trading week underway. Futures were pointing to a lower open. We'll see where things shake out as we get our initial quotes here. We see the NASDAQ is off just about 1% in the early going. Ernesto, let's talk a little bit about valuations right now and sort of how you guys are seeing that equation. We've been talking about valuations elevated for some time now. We have seen earnings come in very strong in the fourth quarter. Expecting more growth as we get into the balance of 2021. What are those conversations like right now that you're having with your clients around valuations? And just sort of how that's playing into your framework today.

ERNESTO RAMOS: Yeah so valuations are a little bit elevated. They have been for a while because of the amount of liquidity in the markets and it's a place to go. So it's going to stocks, it's going to bonds, it's going everywhere. Right now, it's coming off of bonds a little bit at the margin, but there are pockets of opportunity. Especially in the value sectors of the market, financials and more cyclical type companies, industrials, and so on.

So just to give you an example, the Russell 1,000 value is trading 19 times earnings, compared to the Russell 1,000 growth trading at 31 times earnings, and the overall market trading at around 23 times earnings. So these are not the highest levels we've seen. In these earnings, 2021 earnings. Back a month or two ago, you had all those multiples up by about four. And the reason they've come down is not that the market is-- even though the market has gone up, it's because earnings estimates for 2021 have been growing so quickly.

In fact, we're expecting about 40% year on year growth, 2020 to 2021 in terms of earnings. So the earnings estimates being revised upwards have pushed the valuations down on a forward looking basis. So we think the market can continue to do well. It's probably not going to have another year like 2020, but their valuation risk is there even though it's been coming up in the last couple of months because of earnings being revised higher. So the fairness picture, bottom line, is really good. It's looking really good for companies.

- Ernesto, just based on what you're seeing in the market and to your point, valuations are pretty high. Do you think what we're seeing in the market the past week, and I'll include today, is that just profit taking or are we looking at the start of a correction?

ERNESTO RAMOS: So hard to tell right? I mean, who knows when corrections are going to happen except after they've happened. You know, the moves up 5%, I wouldn't be discounting a move of a manage of 5% to 7% here. A correction is 10% from a technical definition point of view. I don't know that we're going to get that because the fundamentals are strong enough just to keep us from getting there. People will jump in as soon as we take a hit here. So I'm not too worried about that.

There are risks that worry me more than a correction. And that's true for example, with corporate taxes. As Biden had announced as a candidate that he was going to raise the corporate tax rate to about 27% or 28% from 21 where it is today. Now, he hasn't mentioned that again, but that's a risk that if it came to happen, that would take that 40% earnings growth if it took place in 2021. Down significantly. And that could be a risk for the market. But just on the economics and the fundamentals alone, the market is looking OK and actually pretty healthy. It's just doesn't have that much upside because it's made such dramatic moves in since the lows of last March and April.

- Ernesto, I do want to dig into that tax thesis a little bit further. I'm wondering, sort of, where you're placing that probability. How likely it is that Biden would actually be successful if in enacting such a tax rate increase if he does indeed go ahead with the plan? And really how significant it is going to be in terms of the effect on earnings? Because we haven't always seen, even when corporate tax rates go up, we have not always seen the hit to earnings that one might have expected, and the hit to markets that one might have expected. So how are you thinking about it?

ERNESTO RAMOS: Well, the problem is law. And the reason that I say that is because the market would have already started to discount it if it were higher. So we haven't seen that hit the market, which essentially tells me as a market observer that the market is assessing a low probability. And so are we. But of course, that's a changing picture. That's a dynamic picture.

And so as we move forward that might start to change and the market will start to reflect that. So today that probability is low. In a couple of months, it may not be low and the market would already start to reflect that. Right now the market has reacted to the sudden move in the 10 year yield. And that is finally catching up with the reality that the reopening and the economic growth underlying the US economy is so strong that has to be reflected in a move upwards in yields. Which again, I don't think is unhealthy at all. It is actually a good thing that we see a steeper yield curve to reflect that strong economic growth that we will see and we have already started to see but will only accelerate as we move forward into year 2021.

- Yes, something that a lot of people have been hoping for. So here it is reflected in those bond yields. Ernesto, thank you for your time this morning, appreciate it. Ernesto Ramos is the CIO at BMO Global Asset Management. Appreciate it.