Figure 1: S&P500 Equity-Bond Yield Relative with Different End-2021 10yr U.S. Treasury Yields
Source: Continuum Economics Note: The equity-bond relative measures take the cyclically adjusted P/E ratio in yield terms minus 10yr real bond yields (in %).
Rising U.S. Treasury Yields and the S&P500 Valuation Question
U.S. 10yr yields have pushed higher in the wake of the Democrats taking control of the Senate after the Georgia runoffs. We now look for more expansive fiscal policy and have revised our end-2021 10yr U.S. Treasury yield forecast from 1.5% to 1.75%. What impact does this have on our S&P500 forecast? A number of points are worth highlighting.
- Further fiscal stimulus will likely increase 2021 S&P500 earnings forecasts, as the U.S. economy would have the double tailwind of still more fiscal policy stimulation and vaccination reducing social distancing. Additionally, though rotation could be seen away from the technology sector, we are doubtful that major changes in technology regulation would occur to materially derail the sector. The incoming Biden administration’s focus is elsewhere, and major regulatory changes are likely to be blocked by the need for bipartisan agreement on non-budgetary issues.
- 2022 earnings growth would face cross currents. The higher 2021 S&P500 earnings starting point and extra economic momentum from the economy are helpful to the projected level of 2022 earnings. This would be at least partially offset by corporate and personal tax increases that will likely kick in during 2022, which will modestly impact corporate profits and behavior of wealthy U.S. investors.
- Equity to Bond yield relative measures would likely be less friendly to equities, but would not leave these measures at expensive levels. Figure 1 shows our new forecast of 1.75% 10yr U.S. yields but with a better earnings forecast, which would imply a higher earnings yield. The bull market in U.S. equities could survive such a rise in 10yr yields.
- Some investors are also focused on 2yr yields and we forecast 0.2% by end-2021, as the Fed will likely strongly maintain its forward guidance on the Fed Funds rate and we do not expect QE tapering until 2022. This leaves earnings yields for the S&P500 with a comfortable premium versus the front end of the U.S. Treasury curve.
Overall, we maintain our forecast of 3,800 for the S&P500 for end-2021 and 4,100 for end-2022. 2021 for the U.S. equity market will likely be a year of earnings recovery being largely offset by multiple derating (largely triggered by rising long-term rates).
What would cause concern for the U.S. equity market is a sharper rise in 10yr U.S. yields. In Figure 1 we show the Equity-Bond yield relative with 2.5% end-2021 10yr yields. This would then leave the Equity-Bond yield measure at expensive levels, which would risk a sharp correction in U.S. equities of 10-20%, as equity-only valuation measures are already very expensive.
However, a rise in 10yr yields to 2.5% would need a lot of issues to turn out wrong. Firstly, the left wing of the Democratic Party would need to get more fiscal stimulus through than expected and risk pushing the U.S. budget deficit toward $4.0trn for 2021. Secondly, this would then have to trigger alarm at the rating agencies over the U.S. government debt/GDP trajectory, after their relaxed attitudes in 2020. Finally, the Fed would have to bring tapering forward from 2022 to late 2021, as overstimulation in 2021 would risk overheating and an overshoot above the average inflation target. All are possible, but low- to modest-risk at this juncture.