A reminder that rising yields, not recession, are most likely to trigger the next equity correction.

Last Wednesday, another hot U.S. employment data point—ADP private sector payrolls—took the U.S 10-year Treasury bond yield rocketing toward 3.25% and levels we haven’t seen for seven years. This was as violent a move as we’ve observed in a long, long time. Along with Tuesday’s announcement of a pay rise at Amazon, last week’s good news for workers lit a fire under global bond yields, and Friday’s steady U.S. wage growth and employment data did little to douse it.

Is this the big adjustment in interest rates that investors have been anticipating for years? Have we finally seen the impact of the shift in Federal Reserve policy? And should it worry equity investors?


There are two ways to look at higher bond yields, of course.

On the one hand, the strong performance of the U.S. economy certainly would seem to justify higher rates. These higher yields are an appropriate response to good economic news: more jobs, higher wages, faster growth. And a 10-year yield at 3.25% is hardly “Bondmageddon” when we have real GDP growth at 3 – 4%, core inflation at 2.2% and the prospect of the Federal Reserve getting three rate hikes in before the end of next year.

On the other hand, perhaps real GDP growth at 3 – 4%, core inflation at 2.2% and the prospect of three more Fed hikes suggest that 3.25% is merely a staging post on the way to something much tighter. As we have all seen in past cycles, higher policy rates from the Fed have often put pressure on equity markets and have been the trigger for recessions, and tighter conditions are a challenge for a world that has 40% more debt than it did before the financial crisis.

The 30-year Treasury yield also soared last week, which will hurt mortgagors and consumers. It’s not good news for the U.S. government, either, with public debt in excess of 100% of GDP.

For corporates, higher rates push up the cost of capital for everyone, but represent an even more substantial threat to smaller, more leveraged, companies. Higher rates also put pressure on price-to-earnings multiples as investors use higher discount rates to value stocks.

Stronger earnings can overcome the impact of higher rates. However, with the tax policy and other fiscal stimuli due to fade through the first quarter of 2019, it is likely earnings will grow at a slower rate in 2019 than we have seen in 2018.

We also need to watch closely how the U.S. dollar reacts to higher yields. The prospect of an even stronger dollar is not good for non-U.S. markets, particularly emerging economies.


It’s not surprising that risk markets, particularly emerging markets, reacted badly last week. And remember, this was just a fortnight after the S&P 500 Index reached its all-time intraday high of 2,941 points, and a few days after markets expressed relief at the agreement of the new United States–Mexico–Canada Agreement. (I guess we’re not calling it NAFTA anymore.)

Equity markets tend not to go up in the straight line we’ve gotten used to since mid-2016. They don’t need a recession as an excuse to correct, either—tightening conditions can push stock prices down even when earnings are sustained. The one blip in that straight line came with the run-up in bond yields earlier this year, after all, and the next blip is likely to have the same catalyst. It could well be bigger. It might have kicked off last week. But even if the current volatility turns out to be another false alarm, we still think it makes sense to use risk-market rallies over the coming months to adopt a more defensive stance.

In Case You Missed It

  • ISM Manufacturing Index:  -1.5 to 59.8 in September
  • Euro Zone Purchasing Managers’ Index:  -0.1 to 54.1 in September
  • ISM Non-Manufacturing Index:  +3.1 to 61.6 in September
  • U.S. Employment Report:  Nonfarm payrolls increased by 134,000 and the unemployment rate fell to 3.7% in September

What to Watch For

  • Wednesday, 10/10:
    • U.S. Producer Price Index
  • Thursday, 10/11:
    • U.S. Consumer Price Index

– Andrew White, Investment Strategy Group

Statistics on the Current State of the Market – as of October 5, 2018

Market Index WTD MTD YTD
S&P 500 Index -0.9% -0.9% 9.5%
Russell 1000 Index -1.1% -1.1% 9.2%
Russell 1000 Growth Index -2.4% -2.4% 14.3%
Russell 1000 Value Index 0.1% 0.1% 4.0%
Russell 2000 Index -3.8% -3.8% 7.3%
MSCI World Index -1.5% -1.5% 4.3%
MSCI EAFE Index -2.3% -2.3% -3.3%
MSCI Emerging Markets Index -4.5% -4.5% -11.5%
STOXX Europe 600 -2.6% -2.6% -5.0%
FTSE 100 Index -2.5% -2.5% -1.5%
TOPIX -1.4% -1.4% 0.6%
CSI 300 Index 0.0% 0.0% -12.8%
Fixed Income & Currency      
Citigroup 2-Year Treasury Index -0.1% -0.1% 0.1%
Citigroup 10-Year Treasury Index -1.4% -1.4% -5.1%
Bloomberg Barclays Municipal Bond Index -0.6% -0.6% -1.0%
Bloomberg Barclays US Aggregate Bond Index -0.9% -0.9% -2.5%
Bloomberg Barclays Global Aggregate Index -1.0% -1.0% -3.4%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.1% 0.1% 4.1%
ICE BofA Merrill Lynch U.S. High Yield Index -0.5% -0.5% 2.0%
ICE BofA Merrill Lynch Global High Yield Index -0.5% -0.5% 0.0%
JP Morgan EMBI Global Diversified Index -1.3% -1.3% -4.3%
JP Morgan GBI-EM Global Diversified Index -1.7% -1.7% -9.7%
U.S. Dollar per British Pounds 0.3% 0.3% -3.3%
U.S. Dollar per Euro -0.9% -0.9% -4.1%
U.S. Dollar per Japanese Yen -0.1% -0.1% -1.0%
Real & Alternative Assets      
Alerian MLP Index 1.8% 1.8% 7.8%
FTSE EPRA/NAREIT North America Index -2.9% -2.9% -0.6%
FTSE EPRA/NAREIT Global Index -3.3% -3.3% -4.0%
Bloomberg Commodity Index 2.0% 2.0% 0.0%
Gold (NYM $/ozt) Continuous Future 0.8% 0.8% -7.9%
Crude Oil (NYM $/bbl) Continuous Future 1.5% 1.5% 23.0%

Source: FactSet, Neuberger Berman.