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Great Reflation Trade Brings New Threats to the Stock Rally

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Justina Lee
·4 min read
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(Bloomberg) -- For the first time in a long time, there’s a conversation on Wall Street about when equities might start to feel the heat from reflation signals in the bond market.

Powered by a rally in oil and bets on further U.S. stimulus, market-derived inflation expectations are near the highest since 2013.

For now, traders bidding up stocks at records are in a sweet spot with the pandemic recovery projected to boost corporate earnings.

But the recent sell-off in benchmark nominal bonds is reminding investors that faster economic growth brings the risk of higher borrowing costs.

Strategists from Jefferies Group LLC to Goldman Sachs Group Inc. are already turning their attention to the next chapter in the fraught relationship between bonds and risk assets.

“As the market prices in these developments, ‘long-duration’ growth and expensive high-profitability stocks will likely be pressured,” said Jim Solloway, chief market strategist at the investment management unit at SEI Investments Co.

A disappointing jobs report released Friday was taken as yet another sign President Joe Biden will prevail in pushing through his stimulus package. Treasury Secretary Janet Yellen added fuel to the reflationary fire on Sunday, stating that the U.S. can return to full employment in 2022 with enough fiscal support. All that sent bond yields higher across the globe Monday trading, before moves whipsawed in New York trading. The S&P 500 Index rose 0.7% to an all-time high.

UBS Group AG analysts see the pain threshold for stocks as a 10-year Treasury yield of 2%. That’s a long way from the current level of around 1.17%, especially while an accommodative Federal Reserve is seen capping rates.

Yet there are straightforward reasons to worry that higher rates will undercut equity allocations. Right now, more than 60% of S&P 500 constituents have a dividend yield above the 10-year Treasury yield. But if the latter climbs to 1.75% by year-end as they expect, that percentage will fall to just 44%, Bank of America Corp. strategists warn.

Another way to consider the relative appeal of equities is the gap between the S&P 500’s earnings yield and 10-year Treasury rates. While that has narrowed to the least since 2018, at 2 percentage points it’s still well above the long-term average.

Faster earnings growth, which in turn supports improving shareholder payouts, could outweigh the drag from higher yields. Among firms that have reported fourth-quarter earnings, 81% have beat estimates, according to Jefferies.

“Higher yields do not beget lower equity share prices if earnings are being revised up just as quickly,” strategists led by Sean Darby wrote in a note.

Another pressure point to consider is interest rates adjusted for inflation, which have staged a big decline since the pandemic to spur stocks higher through the recession.

With the recent plunge in bonds mostly driven by higher inflation expectations, real rates -- as proxied by bond yields minus breakeven rates -- haven’t budged that much. That’s good news for stock investors, since the link between the S&P 500 and inflation bets has been consistently positive since 2012, according to strategists at Goldman Sachs.

“Improving growth expectations often correspond with higher breakeven inflation, rising earnings expectations, and improving investor sentiment, which more than offset the higher discount rate,” a team led by Ryan Hammond wrote in a Sunday note.

Better economic expectations typically help sectors more sensitive to the business cycle like banks and commodities, which tend to fall under the category of value stocks.

JPMorgan Chase & Co. strategists in a note told clients to add domestic value sectors like financials and telecoms.

When interest rates rise, investors also typically prefer the near-term cash flows offered by these cyclical shares, rather than stocks with secular growth -- like Big Tech -- since their long term profits get discounted at higher rates.

Yet megacaps this cycle are in fighting form. The Nasdaq 100 has still managed to narrowly beat the Russell 3000 since bond yields bottomed out from early August.

So while tech belongs to the growth investing style that tends to underperform when rates rise, Goldman strategists argue these days the cohort might be an exception to that rule.

“Their secular and idiosyncratic growth profiles mean that changes in interest rates are unlikely to be a major driver of returns,” they wrote.

(Updates U.S. stock trading in seventh paragraph. A previous version corrected the yield on the 10-year note.)

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