The Tension Between Equities and Bonds

Our Global Head of Fixed Income Research Andrew Sheets examines what rising rates could mean for equity valuations, earnings and investor appetite.

Read more insights from Morgan Stanley.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

Today, thinking about equity resilience in the face of rising bond yields.

It's Friday, October 2nd at 2pm in London.

The benchmark U.S. 10-year Treasury yield has risen about 100 basis points this year. Global equities, at the same time, are up about 13 percent. And those two facts sit in an uncomfortable tension.

After all, higher bond yields give investors better return options elsewhere, and they also make future corporate profits worth less today, which in theory should push stock prices lower.

But there's a wrinkle here.

That valuation theory actually has two moving parts. What we're referring to here is what we would call a dividend discount model or a Gordon Growth Model, where the value of a company today is worth the value of its dividends divided by the difference of its required rate of return and its growth rate.

The higher the required rate of return, which interest rates push up, hurts a stock valuation. It increases the denominator. But a higher growth rate, well, that works in the opposite direction. That decreases the denominator. It makes the company worth more.

Hopefully, this is intuitive. if a company has to meet a higher return hurdle, it will be worth less today. If a company's growing faster, all else equal, it's worth more. And that, we think, goes a long way to actually explain what's going on in markets today. Because corporate profits are growing quickly.

Over the last year, profits for the S&P 500 are up about 30 percent, and the earnings growth for the median company, well, that's still up in the mid-teens. Growth in Europe, Asia, and emerging markets have also been historically strong.

Indeed, if you'd told me on January 1st that the S&P 500 would be up about 13 percent, and at the same time, U.S. Treasury yields would be up about 100 basis points, I probably would have told you with reasonable confidence that stocks would look more expensive relative to bonds.

But they don't. The valuation of the equity market, the P/E ratio, has fallen significantly as yields have risen. But because earnings have risen so much more, stocks are still higher. And the so-called equity risk premium, the difference between the earnings yield and the bond yield, it's pretty stable year to date.

Now there's another way that higher yields could hurt the stock market. They could simply cause people to sell their stocks and buy those higher yielding bonds. But so far, we're not seeing evidence of that. The flows that we track continue to show money flowing into both stocks and bonds.

And the two markets are moving in the same direction day to day. They're showing positive correlation, which is not the outcome you'd expect if people were shifting money from one to the other.

There's also an interesting way that companies have a say in this debate. Investors every day look at the market and decide if these yields are high enough that they want to buy them. But companies look at the same yield and say, "Is this low enough that we would want to sell?" And so especially for the companies that are funding the AI build-out – these large technology companies with so much AI spending to do. Many of them, even at these higher yields, are still saying these are attractive levels to issue at. And are more attractive than, say, issuing more stock.

The other factor that's always important to keep in mind whenever we're debating long-term valuation questions between stocks and bonds, or really any asset class, is that valuation is a slow-moving force. It is often not terribly predictive of the next six or even 12 months. Indeed, if we think about the difference between the earnings yield on the equity market, the inverse of the P/E ratio, and what the bond market yields, that difference. Well, that difference only explains about 10 percent of returns between stocks and bonds over the next month.

Now, valuation is more powerful the longer you give it. And so, extend that horizon out over the next three years and that valuation gap between bonds and equities, well, explains about half the three-year outcome.

Markets are not equations that are solved once a quarter. They are ongoing arguments about the future. And when growth is strong, investors are simply more willing to give growth and that future potential the benefit of the doubt.

We think this goes a long way to helping to explain the equity market's resilience despite Treasury yields moving well above five percent. But it's also raising the bar.

Higher yields simply leave less room for earnings disappointment. Those profits need to keep growing quickly.

Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.