The recent surge in Treasury yields to a peak of 5% has prompted investors to reconsider their stock allocations, as government bonds now offer risk-free income for those who hold them until maturity. This change is attributed to apprehensions about a hawkish Federal Reserve policy and fiscal worries.
In response to the yield increases, fund managers have been overweighting bonds and underweighting stocks throughout most of 2023, according to BofA Global Research. The S&P 500 has felt the impact of these yield increases, falling over 8% since late July, although it remains up approximately 9% for the year.
Rising bond yields not only affect investors but also increase the cost of capital for companies, potentially impacting their balance sheets. Tesla (NASDAQ:TSLA) CEO Elon Musk voiced concerns about the effect of high interest rates on car buyers.
Additionally, when bond yields rise, analysts' models heavily discount companies' future profit projections due to the potential for higher returns from risk-free government debt. The equity risk premium (ERP), which compares the S&P 500's earnings yield with the 10-year Treasury yield, currently stands at 30 basis points - significantly lower than its 20-year average of around 300 basis points.
Historically, when the ERP falls below its average, the S&P 500 has shown average 12-month returns of less than 6%. Investors and the Fed are also considering bond "term premiums" as another factor pushing yields higher. The term premium is at its highest level since 2015 at just below 0.5%. Over the past decade, low bond term premiums have supported high equity valuations.
Current equity valuations might be based on overly optimistic earnings estimates, especially if higher interest rates slow down the economy as many analysts anticipate. S&P 500 companies are projected to increase earnings by 12.1% in 2024.
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