Rising inflation-adjusted yields in the US are undermining long-duration trading in which investors favor stocks over other asset classes, and are poised to hit the tech sector further.
That trade, known as “TINA,” an acronym for “There Is No Alternative” to stocks, is being increasingly tested by real yields, which have risen from below zero on expectations of aggressively higher interest rates by part of the Federal Reserve. Five-, 10- and 30-year inflation-adjusted yields are at their highest or least negative levels in roughly the past two years, according to Tradeweb.
Meanwhile, all three of the major stock indices have had huge successes: the S&P 500 SPX Index,
and Dow Industrials DJIA,
it just finished its worst April performances since 1970, down 8.8% and 4.9%, respectively, for the month. The tech-heavy Nasdaq Composite COMP fell 13.3% in April, its worst result for that month since 2000.
Read: Four tough months for stocks: The S&P 500 posts the worst start to the year since 1942. Here’s what the pros say you should do now.
Real returns are important because they are considered the true cost of capital for corporations, after accounting for inflation.
When they are rising, real yields are bad for investors in stocks and other risky or speculative assets because the price distortions that allowed them to benefit from the Fed’s easy money stance since March 2020 are disappearing. The cost of borrowing money rises, making it more expensive for tech companies to undertake development. In addition, the discount rate, or the rate of return that investors demand to discount future cash flows to present value, is also rising.
“We wouldn’t be surprised if we broke 4,000 in the S&P 500 between now and the summer,” said Lisa Shalett, chief investment officer and head of the global investment office at Morgan Stanley Wealth Management in New York. “A lot of that will be catalyzed by people not only talking about higher interest rates, but living with higher interest rates,” she told MarketWatch.
The chart below shows how far inflation-adjusted stock valuations had plummeted by 2022, according to Morgan Stanley Wealth Management, which manages $4.8 trillion. Although Treasury yields have soared and inflation is at its highest level in 40 years, price-to-earnings ratios in the S&P 500 and Nasdaq Composite have barely budged, the firm said. This implies that, when adjusted for inflation, the stock’s earnings yield, or earnings per share divided by current stock prices, has never been lower.
“The academy suggests that rising real yields should hit all stocks equally, but the problem is that it hasn’t,” Shalett said by phone. “Unfortunately, the correction hasn’t been in the large-cap tech companies, which have multiples that people see as Teflon. We do not believe that opinion is justified. We think the mega-caps could drop another 10-15% while indices drop another 5%.”
In a note this week, Shalett wrote that Morgan Stanley Wealth Management’s global investment committee disagrees with the “no alternative” or “TINA” argument that US stocks should be preferred in a diversified portfolio because they are the only alternative to bonuses and other regional stock allocations.” The committee sees better opportunities in non-US stocks over the next 12 months.
Put simply, when real yields, as measured by rates on Treasury inflation-protected securities, are negative, it’s a sign that the Fed is still technically in a dovish stance: so even if stocks sell off, many investors will look to buy the dip. But as real rates turn more positive, financial markets become increasingly volatile as traders and investors adjust to an environment of tighter conditions and move away from super-loose monetary policy.
A model produced by Quant Insight, which uses artificial intelligence and machine learning to analyze more than 6,000 securities across all asset classes, showed that “macro conditions are getting worse for stocks relative to bonds,” a change from March, according to Huw Roberts, the London-based company’s chief analyst. “The consolation is that to some extent SPY (or SPDR S&P 500 ETF Trust) SPY,
has already discounted some of the bad news,” Roberts wrote in an email.
Gone, meanwhile, is the typical inverse correlation between Treasury yields and the performance of the most prominent US tech stocks: Meta Platforms Inc. FB, formerly known as Facebook Inc.; Amazon.com Inc. AMZN; Netflix Inc. NFLX; and Google’s parent company, Alphabet Inc. GOOG.
During the substantial rise in 2022 yields, market-based rates fell periodically, and during those times, FANG shares tended to rise. In recent weeks, however, FANG companies have underperformed even as rates fell, underscoring a shift in investor sentiment, according to George Ball, president of Sanders Morris Harris, an investment firm with headquartered in Houston managing $4.9 billion.
“We would avoid FANG stock,” Ball told MarketWatch by phone.
“For a decade, FANG stock has been the right place to be in both good and bad markets,” he said. “And until last week, people were willing to overlook the high valuations and business model risks in FANGs. That has changed now.”
Ball’s company began reducing the 15% to 20% exposure it had to FANG shares, either directly or through indices, six months ago, and is no longer looking to add them, he said. There is also an outside risk that the Nasdaq Composite could drop 10% to 12% from current levels by this fall, Ball said.
Read: The real yield on the 10-year Treasury was briefly above zero. This is what it means for the markets.
The highlight of next week’s calendar is the Fed’s policy decision on Wednesday, followed by a press conference by Chairman Jerome Powell.
John Madziyire, senior portfolio manager and head of US Treasuries/TIPS at Vanguard Group’s fixed income group, said he has a hard time seeing the Fed “move the dial,” or do anything else to offer. a 50 basis point rate hike and starting the process of reducing the central bank’s nearly $9 trillion balance sheet on Wednesday.
However, any suggestion that a 75 basis point move could be on the cards would rattle early yields and real rates, the Malvern, Pennsylvania-based portfolio manager says. Markets are currently poised for two more half-point hikes in June and July, he said in a telephone interview.