Higher Yields Give Pause to Rising Equities

Posted: 16th October 2018 15:13

Stock prices have been trending higher for most of 2018.  While US and Japanese equities hit all time highs in September and October respectively, the trend has not been as kind to European shares.  US equities have been buoyed by strong growth and robust earnings, but the recent surge in US interest rates could disrupt the trend. 

Why Are US Rates Rising?

US rates are rising because the US economy is strengthening.  Stronger growth will eventually lead to higher inflation expectations.  To fend off higher inflation the Federal Reserve has been raising short term lending rates. Fed fund rates have increased by 75-basis points so far in 2018, and the market is pricing in a 25-basis point increase in December of 2018.  At the most recent September Federal Open Market Committee meeting Fed Chair Powell, stated that the economy is strong, and the Fed would likely continue to raise rates through 2019. The market is currently pricing in 75-basis points of rate increases in 2019, and an additional 75-basis points of tightening in 2020. The expectations that short-term rates will rise, has back up long-term interest rates to the highest levels of 2018.  The 10-year yield is now near 3.25%, while the 2-year yield is 2.9% the highest level seen in the past 10-years.

Why Are Stocks Faltering

Stock prices have come under pressure as yields move higher. There are several reasons why this occurs. First, stock prices are based on discounted cash flows of future earnings. Discounted cash flows are based on current interest rates. The higher interest rates move the lower the discounted cash flows which makes the present value of stock prices lower.   

A second reason that the share markets is coming under some pressure is that higher interest rates create an additional asset class that can compete with equities. When the 2-year yield was 0.5%, investors where forced into riskier assets such as stocks, but with yields near 3%, an investor can receive a risk free rate of return which now competes with stocks. Instead of investing in equities and receiving a 3% dividend with risk, an investor can buy a 2-year treasury bond and receive 3% with no risk whatsoever.

What Will Put Stock Back on Track

Stock prices in the US should continue to trend higher as strong growth and robust earnings eventually carry the day. Q3 earnings will begin to be reported in October, which should help stock prices resume their trend higher.  Expectations are for earnings to be very strong, which should help buoy the broader indices such as the S&P 500 and the Nasdaq 100.  The FANG stocks, which include Facebook, Amazon, Netflix and Google should also begin to rebound and move higher following earnings season. The only caveat is inflation. While wage inflation appears to be subdued, higher consumer inflation could make the Federal Reserve act quicker than it wants to which would drive up interest rates and put further pressure on stock prices.