The U.S. stock market only had a taste of the potential damage from higher bond yields earlier this year, with the biggest test yet to come, according to Morgan Stanley.
“Appetizer, not the main course,” is how the bank’s strategists led by London-based Andrew Sheets described the correction of late January to early February. Although higher bond yields proved tough for equity investors to digest, the key metric of inflation-adjusted yields didn’t break out of their range for the past five years, they said in a note Monday.
While many have warned that faster inflation could hurt stocks, in theory bigger price gains should be at worst neutral, if they boost earnings along the way. Higher real yields, on the other hand, mean a bigger discount rate to value future earnings. Should they break out of the range over the past five years as investors anticipate greater central bank policy normalization, that could hit stocks harder, according to the Morgan Stanley thinking.
Relatively low real yields were a big support for equity valuations, so a break higher would indicate that stocks will have to rely on earnings — not multiple expansion — to drive them higher, Sheets and his colleagues wrote. And the challenge there is that a slowdown may loom starting in the second quarter, they said.
“It’s when growth softens while inflation is still rising that returns suffer most,” the strategists wrote. “Strong global growth and a good first-quarter reporting season provided an important offset. We remain on watch for ‘tricky hand-off’ in the second quarter, as core inflation rises and activity indicators moderate.”
JPMorgan Chase & Co. strategists have also pointed to real rates as a potential inflection point for markets, though they identified in December the inflation-adjusted cash rate as the one to watch. That measure has a ways to go until their threshold.
— Check out BlackRock Upgrades US Equities to Overweight on ThinkAdvisor.