MW Stocks appear 'rate sensitive once again' as bond yields press higher
By Christine Idzelis
Based on current yield levels, bonds provide a 'really strong insurance policy' in investment portfolios, says Vanguard's Jeff Johnson
Rising interest rates in the bond market seems to be weighing on stocks, as investors wait for an upcoming U.S. jobs report and for Wall Street banks to kick off corporate earnings season.
"Equities are rate sensitive once again," said Morgan Stanley equity strategist Mike Wilson in a note Monday. Rates are "the most important variable to watch in early 2025."
The yield on the 10-year Treasury note BX:TMUBMUSD10Y has jumped over the past month, to slightly more than 4.6% on Monday. The S&P 500 index SPX, a gauge of U.S. large-cap stocks, has slumped in the trailing one-month period.
With the S&P 500 trading at a relatively high valuation, some investors worry that climbing rates could dent the U.S. stock market. The continuation of the S&P 500's rally will hinge in part on company earnings growth, with JPMorgan Chase & Co. $(JPM)$ set to report its fourth-quarter results and guidance next week, while upcoming macroeconomic data could move bond rates.
"We're pretty cautious on interest rates," said Tom Graff, chief investment officer at Facet, in a phone interview. But Graff said he wouldn't worry about the yield on the 10-year Treasury note drifting to 4.8% to 5%, as long as inflation remained broadly under control.
The stock market would rather see higher interest rates on a strong economy - with inflation contained - than lower rates and a "mediocre economy," he said. Still, Graff cautioned that rates rising due to inflationary pressures could stir up volatility in the stock market.
Investors will get a reading on December inflation, as measured by the consumer-price index, on Jan. 15, while the next U.S. jobs report is due out on Friday.
Read: Stock market manages strong start to 2025. But watch for these potential pitfalls.
Meanwhile, "the correlation of equity returns to bond yields has flipped decisively into negative territory (yields up, stocks down and vice versa) -something we have not seen since last summer," Wilson wrote in his note.
"In order to see the return of a 'good is good' backdrop where hotter economic data drives upside in stocks even amid higher rates, we likely need to see more convincing evidence that animal spirits are inflecting and translating into stronger economic activity," he said. "Stickier inflation readings in the absence of this dynamic on the growth front would likely keep equity return/bond yield correlations negative."
The 10-year Treasury note pushing past 4.5% in December drove "narrower breadth" in the U.S. stock market, which saw "a weak finish to what was otherwise a very good year for equity investors," according to Wilson's note.
The S&P 500 booked annual gains of more than 20% in each of the past two years. In 2024, the index rallied 23.3% after gaining 24.2% in 2023, FactSet data show.
Bonds vs. stocks
Vanguard has forecast that equity market gains over the next 10 years will be similar to fixed-income returns over the same period, according to Jeff Johnson, head of fixed income product at Vanguard.
U.S. equity valuations appear "stretched," Johnson said in a phone interview. Although fixed-income investors were stung by losses as inflation and rates climbed in 2021 and 2022, today's higher yields "cushion bond returns going forward," he said.
Bonds provide a "really strong insurance policy against the possibility of valuations normalizing in equities," or underperformance in stocks, he said. "We think it's a pretty favorable-looking environment for fixed income going forward."
Vanguard's 10-year annualized return forecast for aggregate U.S. bonds is 4.5% to 5%, compared with a predicted gain of around 3% to 5% for U.S. equities, according to Johnson.
The yield on the 10-year Treasury note BX:TMUBMUSD10Y rose two basis points Monday to 4.616%, or nine basis points below its 52-week high on April 25, according to Dow Jones Market Data. Bond yields and prices move in opposite directions.
"It's just so tough to consistently time" rate changes over the short term and "get that right across portfolios," said Johnson. "Even if interest rates go up, an investor with an intermediate or longer-term time horizon stands to benefit from higher rates."
The Vanguard Total Bond Market ETF MX:BND, which passively tracks the U.S. investment-grade bond market, returned a total 1.4% last year, according to FactSet data. The actively managed Vanguard Core-Plus Bond ETF VPLS fared better, up 2.7% in 2024 on a total return basis.
The U.S. stock market finished Monday mostly higher, with the S&P 500 rising 0.6%, the Nasdaq Composite COMP gaining 1.2% and the Dow Jones Industrial Average DJIA slipping 0.1%.
The stock market has been trading in a bit of a "vacuum" in terms of fresh information as investors wait for fourth-quarter earnings reports, fresh data on jobs and inflation and President-elect Donald Trump to enter the White House on Jan. 20, according to Graff.
In the meantime, investors should "stick" with quality stocks, in Wilson's view. "The recent rise in rates provides yet another reason to stay up the quality curve as companies with stronger balance sheets" and "less leverage are likely to remain less rate sensitive," he said.
-Christine Idzelis
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(END) Dow Jones Newswires
January 06, 2025 18:58 ET (23:58 GMT)
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