More Stimulus Could Hurt Stocks–Here’s The Indicator To Watch Before It Does

Topline

With details of a massive new stimulus package just one day away, Treasury yields have soared to their highest levels since the start of the pandemic–a sign investors are bullish that the economy is set to recover, but also that inflation and stock market volatility could pick up; here’s what could happen.

Key Facts

Yields on the 10-year Treasury have surged nearly 20 basis points, or 20%, in the past week alone, reaching their highest levels since March in anticipation of another round of fiscal stimulus that will surely require additional government debt. 

Most of the increase has been driven by expectations that inflation will rise as a result of the added relief, Goldman Sachs strategists said in a Monday note, adding that “investors have embraced the reflation trade” as the economy recovers amid unprecedented spending from both lawmakers and the Federal Reserve to stave off a depression.

President-elect Joe Biden is expected to unveil that new stimulus package Thursday, and Vital Knowledge Media Founder Adam Crisafulli says that if he “puts out a huge headline number” that sends yields spiking even further, what results would “likely be a net negative for the overall market.”

“At some point soon higher yields and higher stocks will become mutually exclusive,” he added Tuesday, noting that such a development would undercut high-multiple momentum stocks–whose valuation multiples nearly tripled, on average, during the pandemic–in particular by encouraging investors to move to risk-free Treasury assets.

Meanwhile, Goldman notes that its fund manager clients “fear rising input costs will steepen the yield curve [meaning, yields will increase] and compress equity valuations” as a result of higher-than-expected interest rates and inflation. 

That bearishness echoes recent sentiments from other experts; Morgan Stanley estimates that firms in the S&P 500 could be in for an average 18% valuation haircut, relative to earnings, for every increase of 100 basis points in the yield on 10-year U.S. Treasurys.

Key Background

Stimulus measures have been largely good to stocks since Congress passed the $2 trillion Coronavirus Aid, Relief, and Economic Security Act in March, but rapid inflation and abrupt interest rate hikes that “happen quickly and without warning” represent the biggest risk to the U.S. stock market this year, Morgan Stanley equity strategists said in a note last week about the longer-term consequences of massive government spending during the pandemic. “With global GDP output already back to pre-pandemic levels and the economy not yet even close to fully reopened, we think the risk for more acute price spikes is greater than appreciated,” strategist Michael J. Wilson said, noting that bitcoin’s rapid resurgence is one sign markets are already starting to think currencies like the dollar could be in for an unexpected crash that has ripple effects across asset classes.

Chief Critic

“Alongside the dramatic rally in risk assets over the past year, valuations have risen to premium levels by historical standards,” wealth advisory Glenmede said in a Tuesday note. “That said, many have argued that premium valuations are justified given the unfolding recovery in earnings, as well as a dearth of alternative investment options. While 10-year U.S. Treasury yields now sit above 1%, that may not be enough to outpace inflation, leaving investors little choice but to turn to risk assets for real returns.”

Tangent

Increased stimulus spending to ward off economic inequality and help curb a recession has “come at the expense of government finances,” Kansas City Fed President Esther George said in a speech Tuesday, noting that higher debt levels can threaten financial stability by making markets more sensitive to prospective shocks. She further noted that inflation could trigger severe price spikes in services rattled by Covid-19, such as air travel and hotel accommodation, if companies find it difficult to meet pent-up demand once the pandemic subsides.

Further Reading

Here’s The Biggest Risk For The Stock Market This Year, According To Morgan Stanley Experts (Forbes)

Here’s What We Know About Biden’s Massive New Stimulus Plan (Forbes)

‘Elections Have Consequences’: Goldman Sachs Makes 6 Big Predictions For The Economy This Year (Forbes)

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