- Market Commentary
- By Jack Ablin
- February 5, 2018
Higher Rates and the S&P 500
Bond yields are on the rise. At last check, the 10-year benchmark Treasury note yields more than 2.8 percent; that’s remarkable, considering it flirted with touching two percent as recently as last September. The fact is, the 10-year note’s yield has moved independently of the Federal Reserve’s overnight rate program. That’s because intermediate term Treasury yields are more heavily influenced by European bond rates. 10-year German bunds yield a scant 0.6 percent, keeping demand for relatively higher yielding Treasuries strong. German bund yields were negative as recently as the fourth quarter of 2016. While meager European yields are keeping a leash on U.S. bond yields, European yields are on the rise also, thanks to broadening continental growth and the prospect of a tighter European Central Bank.
Higher interest rates are pressuring the equity market in an environment where stocks were the only game in town. Bonds as a competitive asset class have been fighting with one arm tied behind its back thanks to quantitative easing. Historically, the 10-year Treasury note yield tracked nominal GDP, real economic growth plus inflation. At last reading, nominal GDP is running at around four percent, about 1.2 percentage points above current benchmark yield. The S&P 500’s earnings yield confirms that view. Historically, the S&P earnings yield, the reciprocal of its price-earnings ratio, moved in tandem with the 10-year, triple-B corporate bond rate. In 2009 that relationship split, thanks to quantitative easing. The S&P’s earnings yield is situated about 1.4 percentage points higher than the 10-year, triple-B bond yield.
The bond market’s yield disadvantage enabled equities to trade at a premium to fair value. At last reading, the S&P 500 is trading at an 18 percent premium to earnings and dividends. For years, the cumulative total return of the S&P 500 tracked the cumulative growth of dividends and earnings, the only entitlements of owning the equity market. Since 2013, however, the trajectory of blue chips rose at twice the rate of earnings and dividends, leaving the market relatively expensive. If history is a guide, a four-percent 10-year has the potential to push the S&P 500 18 percent lower, all other things being equal. The likelihood of a four percent 10-year is low in the near term; however, a mid-teen percent S&P 500 correction would represent a long-awaited catharsis, not the precipice of a tailspin.