Surging bond yields have been rattling investors for a year. Why they’re a problem for people hooked on an asset as volatile as equities can be seen by juxtaposing stocks with some of the safest securities in the world.
Treasury bills are rarely cast as a route to riches, but right now their payouts are nearly as high as a similar marker in the equity space: profits generated by S&P 500 companies. While the comparison isn’t quite apples-to-apples, it’s a model sometimes employed to get a sense of relative value across asset classes.
Specifically, six-month Treasury bills currently yield a hair below 5%, the highest since 2007. Meanwhile, the S&P 500 earnings yield clocks in at about 5.08%. The gap between them is the slimmest advantage that stocks have held since 2001.
Wrinkles like these are becoming common, upending the calculus for money managers who have watched stocks’ roaring start to 2023 with hesitation. Signs of sticky inflation and the Federal Reserve’s campaign to quell have reignited worries of a coming economic downturn, while the latest round of gloomy earnings has given the bulls little fodder.
Against that backdrop, relatively juicy yields on cash — which carries virtually zero credit or duration risk — may one day tempt the money now flowing into equities.
“We think we’re headed into economic deterioration and the current volatility in the market is enough for us to be very cautious in equities, and you’re getting paid in the meantime to wait with cash,” said Jerry Braakman, chief investment officer of First American Trust. “So we do think it’s an attractive space to be in fixed income versus equities at this point.”
Stocks have posted a convincing rebound in 2023. After 2022’s more than 19% plunge, the S&P 500 has soared 8% so far this year, defying deteriorating earnings estimates and signs that the Fed will have to continue tightening policy to combat still-hot inflation. While bond traders have bent to Fed speakers’ hawkish messaging and priced in a higher terminal rate over the past two weeks, the S&P 500 is 1.8% higher in February alone.
The speed of the rally is bedeviling strategists who predicted for the first time in at least two decades that the benchmark index would decline in 2023. The S&P 500, on pace for its fifth up week out of seven, is currently trading around 4,150, above the average year-end target of 4,050.
Investors are funneling money into stocks despite the ominous messages from the bond market due to a fear of missing out, according to Penn Mutual Asset Management’s Zhiwei Ren. While clipping coupons in Treasury bills is a more attractive proposition than it has been in decades, memories of returns akin to S&P 500’s 27% surge in 2021 leave equity managers with little choice but to chase the rally.
“If you look at it from a valuations point of view, bonds are much more attractive compared to stocks. But the problem is stock managers manage stocks, bond managers manage bonds,” said Ren, portfolio manager at Penn Mutual Asset Management. “For stock managers, the motivation is not to miss the rally, or underperform. That’s one big driver behind the strong rally we saw.”
Given what short-term debt is yielding right now, the risk-reward of owning them versus the earnings yield of stocks looks better than seen at any time since the great financial crisis, according to JPMorgan Chase & Co.’s Marko Kolanovic. In other words, the spread between the two-year and the equities earnings yield is at the narrowest since 2007.
“Looking at across what yields we’re getting in the front-end of the fixed-income markets, if you own ICSH which basically gives you over 4.6% yield, that makes a lot of sense,” Gargi Chaudhuri, head of iShares investment strategy for the Americas, said on Bloomberg Television, referring to the BlackRock Ultra Short-Term Bond ETF. “The money on the sidelines is chasing the equity market, especially the growthier parts of the equity market that did so poorly — there has to be a reckoning of some sort.”
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