Rate rises erode investors’ incentive to hold U.S. companies’ shares

The yield on three-month U.S. Treasury bills was 5.3 per cent last week after the Fed held interest rates at between 5 and 5.25 per cent.Leah Millis/Reuters

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The dramatic rise in U.S. interest rates combined with the stock market’s recent strong gains have wiped out the reward investors can expect over the next year for owning shares in big U.S. companies, according to analysts.

The yield on three-month U.S, Treasury bills was 5.3 per cent last week after the U.S. Federal Reserve Board held interest rates at between 5 and 5.25 per cent, but signalled that most of its officials expected a further two rate rises this year.

That’s the same level as the expected 12-month forward earnings yield across the S&P 500, which has risen by more than 15 per cent since January. Although it has been one of the best half-years for the index in two decades, it has left investors nervous about the potential for future returns.

“For the first time ever, the yield on cash, bonds and equities is the same,” says Luca Paolini, chief strategist at Pictet Asset Management SA. “If you are a U.S. investor, you should probably buy bonds because, in risk-adjusted terms, they give you more.”

Investors are watching this measure closely, seeing it as a warning that the bull market in U.S. equities could run out of steam.

“Now we have the inflation problem, which has led to monster rate hikes, it means equity markets are much less attractive,” says Christian Kopf, head of fixed income at Union Investment.

“The compression of yields in the U.S. is a very important development and it means people will allocate less to U.S. equities,” he says, adding that the picture was different in European markets, where equity valuations were lower.

While this was largely down to a big proportion of tech “growth” stocks in the U.S., Mr. Kopf says, even after adjusting for differences in sector weightings, “European equities remain cheap relative to the U.S.”

The price-to-earnings ratio on the S&P 500, a closely watched valuation metric, has risen to 23 times this year, reduced to 18 times when the index is measured on an equal-weighted basis compared with 13 times for the Stoxx Europe 600, according to Refinitiv.

In its mid-year market outlook last week, Pictet says it expected European and Asian equities to perform better than their U.S. counterparts in the second half of the year.

“What I don’t like in the S&P today is that two-thirds of the rise, year to date, is linked to five or seven stocks,” says Nadège Dufossé, global head of multi-asset at Candriam. “It’s a vulnerability of the market.”

Higher rates on investment-grade bonds also spell difficulty for more risky and illiquid credit. Mr. Kopf expects investors will “desert” private debt and move back into the listed and liquid areas of the market as part of “the great repricing.”

A survey of fund managers by Bank of America last week showed that investors were the most overweight in investment-grade bonds compared with their high-yield counterparts since 2008.

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