(Bloomberg) — The steepest bond sell-off in history, the first land war in Europe between two sovereign states since 1945, a Federal Reserve adjustment toward a possible slowdown in growth. Oh, and US inflation remains near a four-decade high.
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For all the threats out there, stocks this week hardly felt the fear as developed world markets rallied to levels seen before the Russian invasion of Ukraine a month ago. That is even as Treasury yields soared again and key sections of the bond curve signaled economic trouble.
As the Fed embarks on an aggressive path of policy tightening, it looks like something will have to give. Strategists at Mizuho International Plc are among those warning that risky assets, and eventually economic growth, will not be able to resist the strong pull of a higher discount rate.
However, a growing number of money managers are betting that stock indices have already largely priced in bearish moves in bonds, while all signs suggest the US economy remains in decent health.
“Judging by the performance of risk assets, markets seem to believe that such levels will not trigger a recession or hurt risk assets,” said Janet Mui, head of market research at Brewin Dolphin Ltd. “I think there is a degree of complacency there. ”
Real yields, a key driver for cross-asset valuations, point to growing dissonance. These inflation-adjusted returns are rising, a theoretical reason for investors to reduce exposures to highly valued, high-growth stocks whose earnings potential lies in the future. However, the opposite is happening.
Wells Fargo’s basket of software-heavy stocks is up nearly 20% since March 16, the start of the Fed’s rate-hike cycle. That’s when benchmark US real yields have surged toward a level that triggered a sell-off in January.
Wall Street investors may be numb to the latest Treasury machinations this time around, while healthy earnings growth expectations suggest a buoyant economy.
“Investors are now looking more toward a future where real yields are higher, nominal yields are higher, but not high enough that it’s worth selling more stocks at these levels,” said Luke Hickmore, chief investment officer at abrdn. .
Technical factors may be playing a role. According to strategists at JPMorgan Chase & Co., sovereign and pension funds have already shelled out as much as $230 billion in stocks to meet allocation targets. Now that those moves have been made, strategist Nikolaos Panigirtzoglou says stocks look vulnerable.
“The rebalancing flow from bonds to equities probably supported equities and hurt bonds over the last two weeks. Now that there is not much flow left to rebalance,” he said. “Stocks would look more vulnerable from here if bond yields continue to rise.”
For Peter Chatwell, Mizuho’s head of multi-asset strategy, it’s only a matter of time before rate-sensitive investing styles price out.
“We think the 2.75% rate will be very restrictive for the US and equally important for the global economy,” Chatwell said, referring to the Fed’s projection for the benchmark rate at the end of 2023. “Slow but Sure, risk premiums will rise and earnings expectations should moderate.”
Strategists at Goldman and Bank of America Corp. see a terminal rate of around 3% and 3.25%, something that could affect risk assessments in the wake.
Mui, meanwhile, sees a pain threshold for markets if the US 10-year yield hits 3%.
“Recession risk is still low, but it is building as we head into 2023,” Mui said. A break above 3% would cause investors to reconsider and start preparing for “a recession or a longer downturn,” she said.
For companies of all kinds, higher returns tend to reduce the present value of future earnings streams, all other things being equal. Rising borrowing costs also hurt those with the highest leverage, which could undermine economic activity.
“Now rate volatility can drive growth volatility and that actually becomes a vicious cycle between the two,” said Christian Mueller-Glissmann, managing director of portfolio strategy and asset allocation at Goldman Sachs Group Inc. “That’s a big difference from the last cycle where growth volatility drove rate volatility.”
For now, the stampede into risk assets continues. Inflows into stocks have been outpacing bond inflows eight to one so far this year, data for exchange-traded funds compiled by Bloomberg Intelligence shows.
“Ultimately, it seems likely that there will be a slowdown in growth and fears around a possible recession before yields stop rising and stocks come under more pressure,” said Mark Dowding, chief investment officer at BlueBay. Asset Management. “It will be difficult to pinpoint when it will happen.”
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