With the recent hike in interest rates, bonds yields have continued to rise. The 10 year treasury yield hit 2.5% last week and surpassed the 2% dividend yield of the S&P 500. While hike in interest rates and rising bond yields suggest a strengthening of the economy, it also could signal a potential shift in investor sentiment away from equities. Last week, equity funds saw net outflows of $8.9 billion, the largest outflow in 38 weeks, with $8.3 billion of them going into US based taxable bond funds.
While the recent stock rally has had many attributions – Post election rally, Trump rally etc., one of the main reasons was the infusion of money from investors, who were either on the sidelines or sitting on low yielding bonds, moving to their money into the equity market to avail of asset appreciation and high dividend yields, as such driving up stock prices. With bonds now beginning to yield higher than dividend paying stocks, the fear is that much of the money invested in equities currently will flow back into bonds.
Another effect of higher treasury yields is the outflow of money from junk bond funds. When yields were low last year, many flocked into riskier junk bond funds to get a better return. Now, those funds are witnessing massive outflows as investors figured that the additional risk of owning a junk bond is unwarranted with treasury yields at 2.5%.
With the Fed likely to continue to raise interest rates a couple more times this year, we could witness 10 year treasury bond yields getting closer to 3% although long term bond yields may remain low. What impact this could have on the stock market is the $64,000 question.
Future Wealth’s View
While many believe that the biggest risk to the equity bull market will come from higher interest rates, we opine that weak company earnings would be a better bearish indicator. By mid April, we will begin to get Q1 2017 earnings results from all the major US companies. The estimated earnings growth rate in Q1 2017 for the S&P 500 is 9.0%. This number has been revised down from 12% in Jan 2017 following concerns over falling energy prices. Financials and Technology companies are expected to drive majority of the earnings growth with telecom and industrials companies dragging down growth.
If Q1 2017 earnings season ends well, we are of the belief that stocks might not feel a stiff headwind from bonds until the 10-year Treasury yields hits 4% or 5%. Furthermore, with the Fed likely to hike interest rates a few more times this year, we see little reason to jump into bonds at this time (value of bonds have an inverse relationship to its yield). Given that the Trump team working on a upcoming tax cut, government spending on infrastructure and pro-growth fiscal policies, we continue to remain bullish on the stock market near term.
At a time when fake news, alternative facts, wiretapping and twitter feeds are clogging up our eyes and ears all day everyday, solid Q1 2017 earnings reports from companies next month will be a welcome relief.