As the latest BofA Fund Manager Survey revealed, a growing number of respondents expressed concerns about economic growth amid rising rates and the stronger dollar, and were afraid that the biggest "rail risk", i.e., continued tightening by the Fed into a growth slowdown, i.e. a "policy mistake", could lead to a recession and/or a sharp drop in risk assets.
But while rising rates, a strong dollar and generally tighter financial conditions are clearly a risk to the bullish narrative, the question is at what point do higher rates overcome the favorable impact of stronger growth to pressure risk assets, because with the S&P just shy of all time highs again, that has not happened yet. Or, as Goldman's Ian Wright asks in a Monday afternoon note, "given the rise in US yields, how well risky assets can digest higher rates and when to rotate from equities to bonds" is the question everyone is asking.
Here, Wright makes two observations:
First, "as US yields have risen, the US and global equity risk premium have fallen (Exhibit 1), indicating the value in equities is falling compared with bonds (this has been less true in the UK, Japan and Europe, where the ERP has been more flat, primarily because bond yields have moved less)."
However, at the same time following a very strong earnings season - thanks to Trump tax reform - absolute valuations have also fallen (Exhibit 2), indicating that although drawdown risk is still present, the equity cycle could be prolonged.
So what happens next, and how long before rising rates topple the bullish narrative for stocks?
According to Wright, the answer whether equities will perform well from here "ultimately rests more on growth than rates" and the Goldman strategist going on to show, in the chart below, that historical performance supports this view, "with returns directly related to growth changes but generally unrelated to yield changes after growth is controlled for."
Putting it together, Goldman explains how rates are growth are connected with this punchline:
in 2016/17 higher rates signalled strong growth expectations, which is why equities did well amid higher rates. But at some point higher rates turn from signalling an improvement in growth to signalling tighter financial conditions, which weighs on growth.
The good news is that according to Goldman, "growth will remain strong enough over the next 12 months so that higher rates alone will not drive a sharp turn in the cycle, although they may lessen returns."
What about after 12 months? Well, as readers may recall that's when the Wall Street consensus believes the next recession will begin.
The irony is that recessions are deflationary and tend to send yields sharply lower. Which is odd because just yesterday Goldman was warning that rates are set to spike in the coming years as the US approaches...