Markets and Economy Can stocks stay resilient with higher Treasury yields?

I can think of many years when I’ve used the Green Day line “wake me up when September ends” to start an early fall commentary. Perhaps I need new material. Or better yet, maybe September could simply become less eventful.

Typically, it has been stock investors who wish they could have hibernated through the month. This time, it has been bond investors. (And New York Giants fans like me, who watched their star quarterback go down in the first quarter of the second game.)

There’s no shortage of explanations for the rise in interest rates. It’s fiscal spending. It’s inflation. It’s the correlation with oil prices. It’s the crowding out from hyperscaler bond issuance. It’s stronger economic activity. Or some combination of these.

Count me more in the economic activity camp than the inflation or fiscal spending camps. To me, there’s little indication in the bond market that something more nefarious has been happening.¹ Rates have increased, in my view, because nominal growth has remained resilient enough to support them.²

That doesn’t mean higher rates are inconsequential.

Consider the Caa segment of the credit market, where spreads have widened.³ I wouldn’t call that the proverbial canary in the coal mine for the business cycle. Still, we ignore them at our own peril. These companies have tended to be more leveraged and in many cases face a wall of maturity that could increasingly need to be refinanced at higher rates.⁴ Some also operate businesses that may be particularly vulnerable to disruption from artificial intelligence (AI). Those challenges appear far less evident in higher quality credit in my view. It’s likely not telling us the end of the market cycle is nigh but rather reminds us that risks can emerge as higher borrowing costs work their way through the economy.

Impact of higher rates on market breadth

Higher rates appear to have contributed to a significant deterioration in market breadth.⁵ This shouldn’t be surprising. Utilities and consumer staples face greater competition from higher bond yields. Real estate is rate sensitive for obvious reasons. Meanwhile, performance has rotated back toward technology.⁶ After rolling challenges across different parts of the tech complex, many investors appear to be gravitating again toward companies capable of producing structural growth in a somewhat more challenging macro environment.

For the broadening trade to reengage, we may need rates and oil prices to do more than simply peak. They may need to move lower. That seems plausible if higher borrowing costs and higher energy prices ultimately moderate economic activity.

S&P 500 near all-time high

None of this means that 5% yields can be inherently incompatible with a healthy stock market. Investment grade and high yield (CCC-rated bonds notwithstanding) corporate bonds widened only modestly in September,⁷ while the S&P 500 remained within striking distance of its all-time high.⁸ And for those convinced that stocks have been caught in a mania, consider that the market’s price-to-forward-earnings ratio has declined this year, even as stocks have advanced.⁹ Higher rates have likely played a role, in my view, by restraining multiples while earnings have continued to grow.

Fortunately, there’s little historical basis to assume that a 5% Treasury yield will translate into sustained lower stock valuations. If anything, history has suggested that higher yields can coexist with healthy multiples if those yields reflected stronger nominal growth and rising corporate earnings.¹⁰

We awake from September after a sharp rise in yields to find stock and bond markets have remained resilient. I think there are certainly worse things to wake up to.