Rising Long-Term Rates Loom Over Autumn on Wall Street… (WSJ)
Ilustrartions by ALEXANDRA CITRIN-SAFADI/WSJWSJ, By Karen Langley, August 27, 2023Futures markets show a growing expectation that interest rates could stay higher for longer, exerting pressure on stocks markets show a growing expectation that interest rates could stay higher for longer, exerting pressure on stocks
Jerome Powell’s much-anticipated speech Friday did little to resolve the conflict gripping markets late this summer: whether a rapid climb in interest rates spells doom for the surprising 2023 stock-market rally.
The Federal Reserve chair said inflation remains too high and officials are open to raising rates again, if needed, in his address at the Kansas City Fed’s annual symposium. He suggested that interest rates could stay high for the foreseeable future, keeping borrowing costs elevated and, in turn, pressuring stocks as investors more deeply discount the value of future corporate earnings.
The message wasn’t terribly different from his previous comments, analysts and investors said. But it wasn’t music to the ears of the many portfolio managers who have been crossing their fingers that the fastest rate cycle in decades is finally at an end.
Stocks rose Friday afternoon, a rare advance in an August slog for U.S. indexes, but futures markets showed a growing expectation that rates could stay higher for longer. Higher yields typically dent the attractiveness of risky investments such as stocks by providing opportunities for returns elsewhere in the markets.
Federal Reserve Chair Jerome Powell signaled during his address Friday at the Kansas City Fed’s annual symposium in Wyoming that additional action on raising interest rates could be necessary. Photo: Nathan Howard/Associated Press
“At what point does the bond market provide competition to the stock market in the eyes of investors?” said David Donabedian, chief investment officer of CIBC Private Wealth US.
Although U.S. indexes remain in the green for the year, this month has been difficult for investors in riskier assets. Signs of continued strength in the U.S. economy, a flood of Treasury debt sales and expectations that the Fed could keep rates higher for longer lifted government bond yields to decade-plus highs.
Traders on Friday assigned a 54% probability to the central bank lifting rates again by the end of the year, up from the 32% chance they estimated a week earlier, according to CME Group’s FedWatch tool.
Investors are also foreseeing a longer horizon before the central bank starts to reverse course. By next June, traders see a 62% chance that the Fed will have cut rates from current levels, down from the 83% probability they assigned one week earlier.
Investors will parse a new release Thursday of the Fed’s preferred gauge of inflation, the personal-consumption expenditures price index, as well as Friday’s monthly jobs report, as they try to anticipate the market’s next turn. They will also review earnings reports from the likes of Best Buy, Salesforce and Dollar General.
The creeping shift in the rates picture coincides with signs that the AI trade is fizzling. Nvidia, the graphics-chip maker at the heart of the AI boom, gave another blockbuster forecast on Wednesday while reporting record sales for the latest quarter. But the numbers failed to power a broader market rally. Some analysts have suggested that even a very rosy earnings picture is reflected in the shares.
The recent climb in long-term bond yields, meanwhile, has accentuated concerns that the stock market as a whole is trading at lofty valuations that leave it vulnerable to disappointing news. While buzz about AI and growing confidence in the economy have driven stocks higher this year, forecasts for corporate earnings have risen more modestly. The stronger growth in share prices has left the market looking richly valued compared with history.
“U.S. stocks are really in a difficult position,” said James St. Aubin, chief investment officer at Sierra Mutual Funds. “They’ve been bid up to the point where the earnings multiple is extended and fundamentals will have to validate that move.”
That is especially true, many investors argue, given the recent climb in long-term interest rates. The yield on the 10-year U.S. Treasury note rose to as high as 4.339% in recent days, its highest settle since 2007 and up from 3.956% at the end of July. Rising yields drive up borrowing costs throughout the economy and tend to reduce the prices that investors are willing to pay for investments, such as stocks, that are valued based on future cash flows.
Some analysts place a particular significance on moves in real yields, a measure of the return on Treasury bonds that is adjusted for inflation. Based on 10-year Treasury inflation-protected securities, real yields recently hit 2%, a level not seen since 2009.
Since companies are often able to pass along higher input costs to customers by raising their own prices, these analysts believe that real yields are the appropriate rate to use in gauging stock valuations. Others say real rates are especially important because they show the true cost of money in the economy, aside from fluctuating inflation.
In any case, rising interest rates threaten share prices by offering investors competing ways to earn a return—a major shift in the financial landscape after years of rock-bottom rates led many to believe there were no meaningful alternatives to stocks. Higher rates also ding the worth of future earnings in widely used pricing models. The result, if the market accepted those trimmed-down prices, would be stocks trading at lower multiples of their projected earnings.
“Valuations at some point are going to have to acknowledge the move in interest rates and the real rates,” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. “As your cost of capital goes up, your valuation multiples go down. It is just math.”
The broad stock index is trading at 18.6 times its projected earnings over the next 12 months, according to FactSet. That is up from 16.6 at the start of the year and above the 15.8 multiple at which it has traded on average over the past 20 years.
“In a 2% real-yield world, can you justify a 19 multiple on the market? It seems a little rich,” Donabedian said.
Image: Germán & Co