A trader works at the New York Stock Exchange, Wednesday, Dec. 13.Mark Lennihan/The Globe and Mail
Whether or not Bill Gross and Jeffrey Gundlach are right about the end of the golden era for bonds, the selloff may give pause to equity bulls after a euphoric and overbought rally.
Surging Treasury yields caused a key stock-valuation measure to touch the most overheated since 2010 this week, while the new-year equity rally came to a screeching halt. Shifting expectations about the pace of U.S. interest-rate tightening could be the trigger for a potentially overdue stock correction, according to Goldman Sachs Group strategist Peter Oppenheimer. Bank of America Corp.'s James Barty reckons a taper tantrum and benchmark 10-year yields rising another 50 basis points represent the biggest threat to the equity rally this year.
"If bond markets get spooked about inflation and there's a proper spike, that would be bad for equity markets," Mr. Barty, the bank's head of global cross asset and European equity strategy, said by phone. Still, yields moving higher thanks to strong growth is actually beneficial for stocks, and at these levels "yields aren't a threat to equity markets," he said.
Even so, the highest Treasury yields in 10 months are eating into one of the justifications for buying U.S. stocks that trade above 20-times earnings. Known as the Fed model, the valuation framework says it's fine to own equities as long as their prices compare favorably to bonds.
The gauge plots the S&P 500 Index earnings expressed as a percentage of price, currently at 4.3 per cent, against Treasury rates. But the sell-off in debt has narrowed the advantage enjoyed by stocks to the smallest in more than seven years.
Dropping the Dividend
Not only would a sudden spike in bond yields further throw off this valuation metric -- used by asset allocators -- it may also prompt investors to ditch dividend-paying companies that were once attractive for their regular income.
The S&P 500 gained 2.9 per cent in 2018 through Tuesday, but bond proxies enjoyed less success. Telecom and utility companies in the gauge, which are often noted for their reliable dividends, fell more than 2.5 per cent.
"The markets would be vulnerable to a disappointment" which could come from a change in expectations about the pace of interest rate increases, Mr. Oppenheimer at Goldman Sachs said in a Bloomberg TV interview Wednesday. The bank predicts as many as four hikes in 2018, potentially triggering "some kind of reassessment of the short-term risk," he said.
But it's unlikely investor appetite for equities and risky assets will diminish, according to Pedro Lavirgen, director of fixed-income sales at Citigroup Global Markets Ltd. in Madrid, Spain. There's enough liquidity both to eat up new fixed-income issues and to pile into stocks, he said.
"Risk-on will keep going, despite this," Mr. Lavirgen said. "Even though we'll see corrections maybe in the first three months of the year, they won't be big enough to change the trend."