Should the yield on the 10-Year U.S. Treasury Note reach 4.5%, the S&P 500 Index (SPX) is likely to end 2018 as much as 25% below its record high close on Jan. 26, per a note from Goldman Sachs Group Inc. (GS) as reported by Bloomberg. That would bring the S&P 500 down to 2,155, Bloomberg says, which would be 21.5% below the close on Feb. 27. While this represents a "stress test" scenario, it nonetheless is quite plausible.
Robust worldwide economic growth is creating inflationary pressures that the Federal Reserve is determined to combat through interest rate hikes. Additionally, the Fed has pledged to reduce its massive balance sheet, which also would depress bond prices and raise yields. The 10-Year Treasury Note yielded 2.9% as of the close on Feb. 27. Meanwhile, the Investopedia Anxiety Index (IAI) continues to register extreme worry about the securities markets among our millions of readers across the globe. (For related reading, see: 8 Threats to the Markets in 2018.)
Stress Test vs. Base Case
Investors should note that Goldman's base case forecast is for the 10-Year Treasury Note to yield 3.25% by year-end 2018 and 3.60% by the end of 2019, per Bloomberg and Goldman's U.S. Weekly Kickstart report dated Feb. 16. Additionally, Goldman projects that the S&P 500 will end 2018 at 2,850, which would represent a gain of 3.9% from the Feb. 27 close, and in that report they recommend that investors buy the S&P 500 and sell the 10-Year T-Note.
With the 10-year yield now at four-year highs, the stock market is reacting to changes in the bond market, according to Bryce Doty, a senior bond portfolio manager at Sit Investment Associates, in remarks on CNBC. "Typically, the stock market has sold off and has created a flight to quality that has driven yields down. Everything has changed. You now have a stock market reacting to an uptick in yields and bonds rather than the other way around," he said.
Doty also told CNBC, during his Feb. 22 appearance, that the current environment is "dangerous at worse, uncertain at best." His concern: exploding federal budget deficits, due to a combination of tax cuts and spending increases, while the Fed also plans to reduce its massive balance sheet. He is certain that the Fed will increase rates four times this year, one more than their official forecast. He also told CNBC that, regarding the 10-Year Treasury Note, "10, 20 basis points a month gets you to 4% in a hurry,"
Doty recommends that investors hedge with short sales of bond futures contracts. This is a way to "turn the fear into cheap insurance," as he told CNBC. Former Federal Reserve Chairman Alan Greenspan and respected bond fund manager Bill Gross are among those who have warned that stocks have been propped up by artificially low interest rates engineered by the Fed and other central banks. (For more, see also: Stocks' Big Threat Is a Bond Collapse: Greenspan.)
'The Circle of Life'
A more positive outlook is voiced by Jonathan Golub, the chief equity market strategist at Credit Suisse AG. As he told Bloomberg, "If rates rise from 3%, that's a good thing." He called 3.5% a "neutral level" for stock prices, but added, "If yields rise from 4%, that's a problem." Golub believes that the recent stock market correction was driven by concerns about wage hikes and general inflation that will raise costs and depress profit margins for corporations, rather than by rising yields. He also thinks that the S&P 500 can advance by 5% to 6% even if yields rise by 50 to 60 basis points. Golub spoke to Bloomberg on Feb. 20.
Brian Belski, chief investment strategist at BMO Capital Markets, a division of the Bank of Montreal (BMO), also thinks that rising interest rates will not hurt stocks at current levels. "As earnings go up, the stock market goes up, and interest rates go up, it all works together. We used to call it the circle of life," he told Bloomberg. Strategists at JPMorgan Chase & Co. (JPM), meanwhile, write that current equity valuation multiples of about 18 times forward earnings are sustainable as long as rates remain below 4%, Bloomberg adds.