In a recent report, Bank of America (BofA) strategists have raised concerns over the escalating threat of prolonged higher interest rates, potentially undermining hopes for a soft landing for the US economy and prompting a significant selloff in stocks over the next two months. According to BofA the confluence of elevated oil prices, a strong dollar, and robust bond yields, coupled with tightening financial conditions, heightens the risk of a protracted and challenging economic downturn, possibly leading to exceptionally high levels of yields. This development poses a serious threat to stock prices.
Currently, the consensus probability of a hard landing stands at approximately 20%. However, this risk may escalate further if the convergence of a recession and a surge in unemployment leads to heightened long-term government bond yields. This would occur as markets factor in potential fiscal policy upheaval, with politicians channeling resources to avert social and political unrest.
Of note is the S&P 500 earnings yield, which hovers around 4.6%, notably lower than the three-month Treasury bill yield of 5.5%. This negative differential of -0.9 percentage points marks the slimmest margin since the turn of the millennium. Historically, wide positive gaps between earnings and bond yields have proven remarkably bullish for both stocks and credit. However, when the margin narrows to a negative or near-minimal point, it has foreshadowed unfavorable periods for these high-risk assets.
Throughout this year, optimism in equity markets was anchored on the belief in a smooth economic transition, while the Federal Reserve was perceived to be nearing the conclusion of its interest rate hikes. Nonetheless, the emergence of surging bond yields and escalating oil prices has begun to erode this narrative. This shift in sentiment has prompted investors to adopt a more guarded approach over the past week, with money market funds attracting an impressive $68.4 billion in inflows—a two-month high. Since the outset of the year, cash reserves have already accumulated a staggering $1 trillion in assets, as reported by EPFR. Within Bank of America’s private clientele, there has been a discernible shift towards money markets, elevating cash allocations to 11.7% of portfolios.
With high interest rates and mounting inflationary pressures looming, stock prices face a formidable challenge. Consequently, investors will be closely monitoring the Federal Reserve’s actions in the months ahead. Should the Bank of America strategists’ prognostications prove accurate, a substantial negative gap between the S&P 500 earnings yield and US equity yields, coupled with heightened inflation, could precipitate a prolonged bear market, potentially spanning several months.
Source: Bloomberg
