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Lofty valuations and record U.S. corporate debt make rising bond yields a risk to the stock market, according to Andrew Lapthorne, head of global quantitative research at Société Générale.
Investors have shrugged off increasingly expensive U.S. stocks in recent years for a number of reasons, including solid earnings, low interest rates and nearly absent inflation. But as both yields and inflation rise, earnings might not be enough to propel stocks higher.
A correction in February that sent the S&P 500 down more than 10% combined with a near-20% expected increase in earning growth has lowered the trailing and forward price to earnings ratios. However, both measures remain above historical averages.
According to FactSet, the 12-month forward PE of the S&P 500 is at 16.5, far above the 5-year or 10-year averages at 16 and 14.2, respectively.
Lapthorne said high U.S. corporate debt is one of the reason why investors are concerned about rising borrowing costs.
The yield on the 10-year Treasury note , a benchmark for interest rates touched and briefly traded slightly above 3% for the first time in more than four years on Tuesday, and remains near 2.98%. That’s still historically low. But higher rates and rising debt servicing costs could present a challenge to U.S. companies, whose leverage is at record levels.
According to FactSet, the total debt to total equity ratio is at 95.5, the highest level since 1999. In February, S&P Global Ratings warned that the number of defaults by heavily indebted companies could rise significantly amid tightening credit conditions.
In a chart below, they show that U.S. companies (excluding technology firms) have continued to borrow in capital markets while Japanese companies de-levered.
Higher debt servicing costs could diminish the pace of buybacks, though that has yet to happen. In 2017, S&P 500 companies spent more than half a trillion dollars on buybacks. Goldman Sachs analysts expect companies to spend $650 billion this year.
In a note, Lapthorne said he expects the downward trend in share buybacks “to continue in 2018 (contrary to all the zero obligation buyback announcements), for the simple reason that most companies simply cannot afford them.”
Lapthorne has other reasons for being cautious about U.S. equities.
The relationship between quality stocks or bond proxies (usually defensive sectors such as consumer staples or utilities) and bonds is positive, while a “cyclically exposed value factor has a consistently negative correlation,” he said.
Indeed, as yields declined over the past several years, prices of quality stocks soared, taking their valuations to near record levels. However, over the past three months, defensive sectors, such as consumer staples suffered the most. The S&P 500 consumer staples sector fell 15% over the past three months, compared with 6.8% decline for the broader index.
“In the S&P 500, for example, our equal-weighted value factor represents just 15% of the market cap. Quality on the other hand makes up 30% of the index. The risk is that as bond yields head higher, the valuation headwind on expensive quality stocks overwhelms the cyclical EPS growth required to push value factors forward,” Lapthorne said.
In other words, earnings alone aren’t enough to push prices higher, however they may just be enough to keep stocks from falling for now.
“Stocks would be down a lot more if it weren’t for earnings growth. It is this double-digit increase in profits that is keeping the floor under the stock market,” said Kate Warne, investment strategist at Edward Jones.
Warne said that the potential for a surprise in inflation is a lot bigger, which is why investors are concerned about it.
“Investors already knew that earnings would be great and companies would beat the solid double-digit returns. So, there was not a whole lot of unpredictability there. However, people aren’t sure if the next move in inflation will be up or down,” Warne said.
There are many reasons for the yield on the 10-year Treasury note to rise, including huge fiscal deficits that mean an increase in government borrowing, and the continued unwinding of the Federal Reserve’s balance sheet.
But any meaningful selloff in equities could also send investors scurrying back to safe assets, such as long-dated Treasurys, pushing yields lower.
Meanwhile, inflation is ticking up. The Fed’s preferred measure of inflation, the personal-consumption expenditures index in the 12 months ending in February, was at 1.8%. At current pace, it is likely to reach or exceed the Fed’s target of 2% fairly soon, especially if commodity prices continue to rise due to a combination of factors, including rising trade tensions.
Warne said that forward valuations, which are lower now than they were a year ago, present long-term, rather than short-term, risk to equities in the form of lower returns.
“Considering solid earnings, our outlook for stocks this year hasn’t changed—we still expect stocks to climb this year. However, given where valuations are, investors should be more careful about long-term returns, which are likely to be lower than what we have become accustomed to over the past several years,” Warne said.