Figure 1: 12mth Forward S&P500 Yield minus BAA High Yield (Actual and Projected) (%)
Source: Continuum Economics, Datastream
Treasury and High Yield Headwind to Equities
The rise in long-dated Treasury yields has dramatically slowed, rather than reversed, the rally in U.S. equities and will remain a strong headwind for U.S. equities. Our March Outlook highlights our central strategic view that rising long-dated Treasury yields will largely counterbalance corporate earnings growth, and we see the S&P 500 at 3,900 end-2021 and 4,100 end-2022. We project the 10yr Treasury yield reaching 2.05% end-2021 in our base-case scenario. The 12mth forward earnings yield for the S&P500 minus BAA high yield is already lower than the five-year average (Figure 1).
Intermittent corrective phases (less than 5%) are likely in U.S. equities, but the support for the market comes from an economic recovery fueled by reopening, huge excess savings and the COVID relief fiscal packages. Tactically it will be difficult to predict 10%-plus corrections, as the market will be hopeful that S&P500 earnings exceed the current expectation of 24% for 2021 and 15% for 2022. The tug of war between rising yields and corporate earnings will carry on all year.
To help illustrate the tension between the two main drivers, we show two scenarios in Figure 1 comparing projected 12mth forward earnings yields for the S&P500 versus BAA high yield. The BAA high yield is based on a 1.9% end-2021 10yr yield forecast and a widening of the BAA-10yr yield spread by 25bps. In 2009, 2013 and 2017-18, rising 10yr Treasury yields saw a narrowing of the BAA high yield to Treasury spread (Figure 2), as higher yield attracted fixed-income investors into high yield during the Treasury selloff. The problem in 2021 is that the starting yield for high yield is 150bps lower than the 2013 taper tantrum, and thus high yield total returns in 2021 will likely struggle to be positive, as capital losses offset coupon payments. This is why we look for an abnormal modest spread widening of BAA versus 10yr Treasuries.
Figure 2: BAA-10yr Yield Spread (%)
Source: Continuum Economics
Even so, in this base-case scenario the earnings yield minus high yield spread remains positive, though still below the five-year average. However, if we plug in our alternative scenario of 2.25% 10yr yields and the same BAA-10yr bond yield spread, then the earnings yield to high yield spread (adverse scenario in Figure 1) narrows to levels last seen in 2006-07. This would likely be enough to trigger a 5-10% U.S. equity market correction, and it could be larger.
The other main catalyst for a correction would be a major resurgence of COVID cases and hospitalization caused by an adverse mutation that significantly reduces the effectiveness of vaccines (i.e. Brazil rather than UK variant). This would slow the opening up of the U.S. economy, but also keep voluntary social distancing from more cautious members of U.S. society. Some focus recently has been on a pickup in COVID cases in Michigan and the East Coast, but this has been driven by the UK variant where vaccines are still largely effective. Provided that this remains the case, then the broad and fast U.S. vaccination campaign should continue to break the link between COVID cases and hospitalization and deaths, and by June this should be a low to modest probability scenario.