Traders on the New York Stock Exchange.
Source: New York Stock Exchange
According to Goldman Sachs strategists, rising bond yields that have shocked investors in recent weeks are far short of anything that poses a broader threat to the market.
Longer-term government bond yields have reached the levels last seen before the Covid-19 pandemic statement in March 2020. The rise has raised concerns that faster economic growth could generate inflation and pose a threat at a time when the S&P 500 is at a level of valuation not seen since the dotcom bubble.
The S&P 500 fell 2.45% last week amid an increasingly volatile market environment.
However, Goldman insists that while rates have indeed gone up, they are not blinking danger signals.
“Investors are asking if interest rates are a threat to equity valuation. Our answer is an emphatic ‘no,'” said David Kostin, the company’s US equity strategist, in his weekly note to clients.
The yield on 10-year Treasury bonds, used as a measure of fixed-rate mortgages and some other forms of consumer debt, last traded at 1.43% Monday morning. That’s off the 1.54% peak on Thursday, but otherwise it’s around the highest since late February 2020 and higher than it started in 2021.
That has come at a time when the S&P 500 is trading at 22 times expected earnings, which Goldman says is in the 99th percentile since 1976, suggesting valuations could be a threat, especially in a rising interest rate environment.
But Kostin notes that investors should see the trend more as a shift than a danger.
If we compare the S&P 500 distributed yield to the 10-year yield, only valuations are shown in a mid range – around the 42nd percentile.
In this environment, investors must recognize that different industries will benefit, Kostin said.
Cyclical stocks, with weaker earnings but stronger growth profiles, will overcome defensive moves that performed well during the pandemic rally. Areas such as energy and industry and services typically perform better when interest rates rise.
“Unsurprisingly, these cyclical stocks are positively correlated with both nominal and real interest rates,” Kostin wrote. “In contrast, very long-term stocks are negatively correlated with interest rates, as they are not generating a profit today and their valuation depends entirely on future growth prospects.”
The rates won’t pose a significant threat to stocks until the 10-year-old hits 2.1%, he added. For now, the environment of rising revenues along with growth is “consistent” with the 4,300 S&P 500 price target for 2021, a forecast implying 13% growth from Friday’s close.
“Looking ahead, investors need to weigh the appeal of promising companies against the risk that interest rates will rise further and continue the recent rotation,” Kostin said. “While secular growth stocks may remain the most attractive assets in the long term, those stocks will underperform more cyclical companies in the short term as economic acceleration and inflation continue to lift interest rates.”