Rising real returns threatens the main driver of long-term stock market gains — and puts tech names even more at risk

Rising inflation-adjusted yields in the US are undermining the long-term trade in which investors prefer stocks over other asset classes, preparing to hit the tech sector harder.

This trade – known as TINA, short for stocks – is increasingly being tested by real yields, which have risen from below zero on expectations of aggressively higher interest rates by the Federal Reserve. Five, 10 and 30-year inflation-adjusted yields have been at their highest or at least negative over the past two years or so, according to Tradeweb.

Meanwhile, all three major stock indices took massive hits: the S&P 500 SPX,
-3.63%
and Dow Industries DJIA,
-2.77%
It just finished off its worst April performance since 1970 — down 8.8% and 4.9%, respectively, for the month. The tech-heavy Nasdaq Composite fell 13.3% in April, its worst showing for that month since 2000.

Read: Almost 4 Months for Stocks: The S&P 500’s Worst Books Are Starting a Year Since 1942. Here’s What the Pros Say You Should Do Now.

Real returns are important because they consider the true cost of capital for companies after accounting for inflation.

When it goes up, real returns are bad for investors in stocks and other risky or speculative assets because the price distortions that have enabled them to take advantage of the Fed’s easy money position since March 2020 will disappear. The cost of borrowing money goes up – which increases the cost of technology companies developing. In addition, the discount rate, or the rate of return that investors are required to discount future cash flows to their present value, is also increasing.

“We wouldn’t be shocked if we broke 4,000 on the S&P 500 between now and the summer,” said Lisa Chalet, chief investment officer and head of the global investment desk at Morgan Stanley Wealth Management in New York. “A lot of that will be motivated by people who are not only talking about higher interest rates, but also who are living with higher interest rates,” she told MarketWatch.

The chart below shows how much inflation-adjusted stock valuations will decline before 2022, according to Morgan Stanley Wealth Management, which manages $4.8 trillion. Although Treasury yields and inflation are at a 40-year high, the S&P 500 and Nasdaq Composite’s P/E ratio is barely budging, the company said. This means that when adjusted for inflation, the dividend yield – or earnings per share divided by current stock prices – has never been lower.

Source: Bloomberg, as of March 31.

“Academia suggests that the rise in real returns should damage all stocks equally, but the problem is that it hasn’t,” Shalit said by phone. “Unfortunately, the correction has not occurred across the big tech companies, which have multiples that people see as Teflon. We don’t think that opinion is justified. We believe megacaps can drop another 10-15% while the indices are down another 5%. “.

In this week’s note, Shalit writes that Morgan Stanley Wealth Management’s Global Investment Committee disagrees with the “no alternative” or “Tina” argument that US stocks should be preferred in a diversified portfolio because they are the only alternative to bonds and to other regional equity allocations. The commission offers better prospects in non-US stocks for the next 12 months.

Simply put, when real returns, as measured by rates on Treasury inflation-protected securities, are negative, that’s a sign that the Fed is still technically in a favorable position: so even if the shares are sold, many investors will be looking to buy a dip. . But with real rates turning positive, financial markets are becoming increasingly volatile as traders and investors adjust to an environment of tighter conditions and shift away from ultra-loose monetary policy.

A model produced by Quant Insight, which uses artificial intelligence and machine learning to analyze more than 6,000 securities across asset classes, showed that “macro conditions are getting worse for stocks relative to bonds” — a shift since March, according to Huw Roberts, the company’s head of analytics. It is based in London. The consolation is, in a sense, the SPY (or SPDR S&P 500 ETF Trust),
-3.70%
It’s already pricing in some bad news,” Roberts wrote in an email.

Meanwhile, the typical inverse relationship between treasury returns and stock performance for America’s most prominent tech company: Meta Platforms Inc. has faded. FB, formerly known as Facebook Inc.; Amazon.com Inc. AMZN; Netflix Inc. NFLX; and Google’s parent company, Alphabet Inc. GOOG.

During the boom in returns in 2022, market-based rates periodically fell – and during those times, FANG stocks tended to rise. However, over the past few weeks, FANG firms have underperformed even as prices declined, confirming a shift in investor sentiment, according to George Paul, president of Sanders Morris Harris, a Houston-based investment firm that manages $4.9 billion.

“We will avoid FANG stocks,” Paul told MarketWatch by phone.

“For a decade, FANG stocks have been the place to be in both good and bad markets,” he said. “Until last week, people were willing to overlook high valuations and business model risks in FANGs. Now that has changed.”

Ball began reducing its exposure from 15% to 20% on FANG shares, either directly or through indices, six months ago, and is no longer looking to add to it, he said. There is also an external risk that the Nasdaq Composite will fall as much as 10% to 12% from current levels by this fall, Ball said.

Read: The real yield on 10-year Treasuries briefly rose above zero. This is what that means for the markets.

The highlight of next week’s calendar is the Federal Reserve’s policy decision on Wednesday, followed by Chairman Jerome Powell’s press conference.

John Madzier, senior portfolio manager and head of US Treasury/TIPS at the fixed income group of the Vanguard Group, said he is struggling to see the Fed “move the dial” — or do more than deliver a 50 basis point increase and start the central bank’s balance sheet reduction process. $9 trillion – Wednesday.

However, any suggestion that a 75 basis point move might be in the cards would destabilize front-end returns as well as real rates, says a portfolio manager at Malvern, in Pennsylvania. He said in a phone interview that markets are currently poised for an additional half-point increase in June and July.

On Monday, S&P Global’s US manufacturing PMI, the Institute for Supply Management’s manufacturing index, and data on construction spending are released. On Tuesday, March data on job vacancies, layoffs, and factory orders were released — along with an April report on auto sales.

Next day’s releases are the ADP employment report, the final reading of the US services PMI from S&P Global, the ISM services index, and the international trade balance data.

Thursday brings weekly jobless claims and first-quarter data on productivity and unit labor costs. On Friday, the nonfarm payroll and unemployment rate for April were released, along with consumer credit data for March.

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