How much of a rise in yields would it take to upend the bull market in stocks? Maybe not as much as investors think.
Strategists at Société Générale say if longer-term yields begin to recover, asset valuations could look particularly steep once the risk-free rate, usually the 10-year Treasury yield rose.
Value investors like Warren Buffett will often discount the free cash flow of a company on the basis of the risk-free rate to assess a stock's value. Free cash flow refers to excess cash after all capital expenditures. If the risk-free rate rises, the overall value of this stockpile of cash accordingly shrinks.
"As a result, falling risk-free rates lead to rising asset prices. This has been the case for U.S. equity as well over the last few years," they said.
By their estimate, the U.S. equity market could shed 15% of its value if the 10-year Treasury yield hit 2.75% (see chart below).
An annual survey conducted by J.P. Morgan showed 31% of those polled forecast the 10-year Treasury yield to push above 2.75% by the middle of next year.
The last time the 10-year yield touched that level was in April 2014. The benchmark's yield has remained trapped in a tight range of 2.6% to 2.0% since Nov. 2016.
Even as the Federal Reserve stays on track to raise rates a few more times in 2018, market analysts have said the chance of longer rates heading higher in the near future is diminished amid tepid inflation. Core inflation as measured by the PCE price index, which strips out volatile food and oil prices, rose to a 1.3% annual rate in the third quarter, up from 0.9% in the second quarter, but well below the Fed's 2% target.
Indeed, minutes of the Fed's November policy meeting released Wednesday showed policy makers are growing more worried about persistently subdued inflation.
The strategists at Société Générale also argued higher bond yields could make stocks look more expensive through another channel. They said higher borrowing costs could have an "impact on the earnings trajectory" as it became more expensive for companies to finance the investment projects. Lower profits would boost the price-to-earnings ratio if stock prices remained steady.
But Jonathan Golub, chief U.S. equity strategist for Credit Suisse, in a Nov. 13 note made a similar observation about earnings, but argued that the evidence indicates the market seems to "prefer when rates are near some long-term average."
His research showed that the price to earnings multiple, a key gauge of stock market valuations, has tended to float higher until the 10-year yield reached a threshold of 5%. Although in the current low-growth environment, that "tipping point has likely fallen to 3.5%." The forward 12 month price to earnings ratio for the S&P 500 currently sits at 18.0.
"With Treasury yields below 2.5%…this implies that stock valuations will not be challenged by rising rates for quite some time," said Golub.
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