An improving macroeconomic backdrop, fueled by significant fiscal impulses, could continue to support Wall Street.
So far the newly sworn-in Joe Biden administration has primarily focused on fiscal support for the pandemic hit US economy, with more strategic initiatives expected to come later this year. The current environment augurs well for risky assets such as stock markets but rising fixed income yields could change that, according to a report by Deutsche Bank. “The US equity risk premium remains historically high, but rising fixed income yields will have a varying impact on different equity styles and sectors,” the report said.
Increase in yield could attract asset allocators
An improving macroeconomic backdrop, fueled by significant fiscal impulses, could continue to support Wall Street. There could be potential future headwinds from added regulations and taxes, which Joe Biden has proposed. However, the note added that Democrats’ thin majorities in Congress could hit those plans for now. In an improving macroeconomic cycle, equity investors benefit from rising stock prices as earnings improve. The situation also sees the rise of fixed income yields that begin to win back asset allocators’ attention as the risk/reward balance shifts back to fixed income’s favour, according to the note.
Risk reward still high for equities
However, the move is not expected to be immediate. Deutsche Bank further added that although higher rates may mean some compression on common valuations, that may not necessarily result in negative price returns. “In reality, the behaviour of markets is typically more nuanced, and in short, it will probably (be) a much more violent increase in Treasury yields from current levels to begin to negatively impact equity price performance,” the note said. Currently, the risk premium between S&P 500 earnings and 10-year U.S. Treasury is lower than where it was earlier last year but still remains positive. “The current premium puts it in the fourth quintile rank (as measured since 1962, which has historically resulted in low double-digit equity returns on average,” they said.
Rising fixed income yields result in different impacts on certain equity styles and sectors. In a scenario where real interest rates force nominal yields to rise, the note said that would result in negative impacts on defensive and higher-quality growth valuations. In a case where higher inflation is to be blamed, then capital intensive firms are likely to take the fall. “The implication is that investors may consider companies with CAPEX-lite business models or with a higher percentage of intangible assets as better positioned to thrive in a higher inflation regime,” the note said. Financials have historically had a strong positive correlation with rising interest rates and steeper curves, while sectors such as Utilities and Real Estate, face a negative correlation.