By Jamie McGeever

ORLANDO (Reuters) – Rising bond yields don’t always mean bad news for stocks or other riskier assets. However, the current surge is giving investors cause to be concerned as they head into the fourth quarter.

This is against the backdrop of stretched Wall Street valuations, slower economic growth, and declining consumer sentiment. Although volatility remains largely inactive across all asset classes and is still largely comatose, there are signs that it may be coming back to life.

This was the worst month for March since last year.

This is due to the Fed’s announcement that they will increase interest rates sooner and more aggressively than originally thought in order to control inflation. It is possible that the Fed might pull the trigger this time around, as there are some signs.

Bank of America (NYSE 🙂 states that the markets have entered the “second phase of interest rate grief”. This means higher borrowing costs are not indicative of a healthy economy, but can be interpreted as doubts about the strength of the economy, growth and asset prices.

Rising yields in the first stage reflect optimism and draw flows into assets leveraged to growth like corporate debt. Credit spreads narrow and the vicious cycle is perpetuated.

As the economic and equity market declines become more apparent, the second stage becomes “more terrifying”. Stock and corporate bond buyers turn defensive.

The third stage is when interest rates stabilize at higher levels, and buyers start to return in. Is there evidence that higher interest rates may be starting to bite?

The S&P 500 rose 33 basis points each month in January and February. During that 66 bps backup in long-term borrowing costs, the S&P 500 rose 6.5%, chalking up several new highs along the way.

The 21 basis-point rise in the 10-year yield over the course of September, however, coincided with a fall in the S&P 500 of 4.76%, the biggest monthly pullback since March 2020.

Markets still seem sluggish. The benchmark index is almost doubled since March 2013, when it was at its lowest point in pandemics. Valuations are also historically high.

The S&P 12-month forward price/earnings ratio has receded a bit lately, but is still comfortably above 20 and near the peaks that preceded the tech crash over two decades ago. Shiller’s real P/E ratio is a warning sign.

Moving out of the risk curve, U.S. High Yield “Junk” Credit Spreads are just above 300 basis point, their lowest levels since mid 2007

Crash Diet

Investors will look for ways to increase annual returns, and end the year with a bang, particularly if recent turbulence abates in the next weeks, and the U.S. debt limit crisis is resolved or pushed towards year-end.

It is clear that there is a tendency to positive Fourth Quarter. The S&P 500 has risen in all but seven of the past 40 October-December periods, and recent investor surveys still show a strong preference for equities over bonds.

The pervasive market sentiment still favors buying the dip.

Citi’s Matt King points out that Wall Street’s surge after the pandemic has significantly outstripped corporate and economic profit growth while credit growth is currently shrinking. According to King, stocks are only held up by the fact that they aren’t bonds. Despite the recent rise in yields, these real yields remain deeply negative.

With economic growth slowing, these are the perfect conditions to make a change. Economists are lowering their fourth-quarter GDP estimates, and data this week showed U.S. consumer sentiment falling to a seven-month low https://www.reuters.com/world/uk/us-goods-trade-deficit-increases-august-2021-09-28.

The winter ahead may prove to be more cold for the markets. The Delta variant still hangs over businesses and consumers, and U.S. policies around COVID continue to be divisive.

Julie Biel (portfolio manager, Kayne Anderson Rudnick) warns markets that they may be more prone to an unhealthy diet than a weight-reduction program.

It’s been volatile. She said that people are emotionally affected.

(By Jamie McGeever, Orlando, Fla. Editing by Matthew Lewis