If rising cost of equity appears to exceed growth rates, company valuations will fall and equity investors will have a problem.
Just as dreams can turn into nightmares, a good rise in bond yields can be worrisome for the markets. The return of the 10-year US bond has doubled in less than five months and yesterday reached a one-year high at 1.45%. That increases the cost of borrowing for companies and makes their current cash flow worth less to equity investors because a higher discount rate is applied.
Stock markets tend to bear the situation if the cause is the best prospects. That is certainly the case so far. Biden’s big stimulus plans will fuel a rebound in activity. A record number of participants in Bank of America’s survey of global fund managers expect to see a stronger global economy in 2021. Thus, while markets have shaken this week, the S&P 500 is up 12% in the period. in which the return of the 10-year bond has doubled.
The Fed is also helping investors focus on the positives. On Wednesday a clear message that the tightening of monetary policy is very far: it will not raise rates until inflation exceeds 2%, a situation that could take more than three years. They may want to wait until they are sure of recovery. But it is a new risk for investors. The Fed now wants inflation to exceed 2% for a time, but does not specify how much and by how much. A larger-than-expected increase would cause bond returns to rise significantly. If rising cost of equity appears to exceed growth rates, company valuations will fall and equity investors will have a problem.
And another thing. In past decades, the Fed slammed on the monetary brakes when growth began to lift prices. You may have to hit the pedal harder than in the past if excess inflation causes wages to go up as well, creating a loop. Neither of these problems is immediate. But investors should have an aspirin on hand.