Global bond yields have continued to rise. The US ten-year yield is now around 5.3%, a level last seen in 2002, and UK 30-year gilt yields have touched 6%. Yet the S&P 500 sits near its record high and the Nasdaq 100 has set a new one. Last month we argued the rise has been primarily cyclical; this month we ask what that implies for equities. The answer depends less on how far yields rise than on why.
Why the source matters
Higher yields reach equities through several channels: the cost of corporate debt, consumer spending, valuation and the wider effect of tighter financial conditions. Each has its own speed and its own winners and losers. A rise driven by growth, by inflation expectations or by the term premium, the extra return investors demand for holding long-term bonds, carries quite different implications.
The cost of debt
The most direct channel runs through corporate balance sheets. A company that borrowed at 2% in 2021 and must refinance at 6% sees its interest bill triple. This cycle is unusual, however. Many large companies locked in fixed rates when rates were near zero, and the largest US technology firms often hold more cash than debt, so higher rates raise their interest income. For the companies that dominate the main indices, higher yields have been a modest benefit.
Smaller companies rely more on floating-rate debt, which reprices quickly, and many are unprofitable. The Russell 2000 is down nearly 10% from its August high and the equal-weighted S&P 500 nearly 6%, whilst the capitalisation-weighted index remains close to its peak. Credit default swap spreads have widened, and private credit shows renewed distress: listed vehicles have fallen sharply and several non-traded funds face redemption requests above their quarterly limits. So far the stress has stayed contained.
The consumer: slow transmission, record equity exposure
Mortgage structure sets the pace for households. Most UK borrowers fix for two to five years, so a cohort moves to higher payments each year. Most US mortgages are fixed for 30 years, insulating existing borrowers and placing the burden on new buyers. This helps explain resilient US consumption and a frozen housing market. Unsecured borrowing, car finance and credit cards reprice faster and weigh most on lower-income households. Savers, typically older and wealthier, now earn a meaningful income on cash and bonds for the first time in 15 years. The net effect is a redistribution from borrowers to savers that may leave total spending little changed.
Equities account for a record 38% of US household net worth and 48% of household financial assets. Individual investors tell surveys they are bearish, yet hold around 72% of their portfolios in shares and 13% in cash. A strong equity market is supporting consumption, and the effect would be equally powerful in reverse. Governments are borrowers too: in the UK and the US, debt interest now exceeds defence spending.
Valuation: what the equity risk premium does, and does not, tell us
The equity risk premium, the gap between the earnings yield on equities and the government bond yield, sits near its lowest level in over 25 years in the US and briefly turned negative earlier this year. History is more nuanced than this sounds. Over the past quarter-century, nominal yields at or above today’s levels have not generally produced equity bear markets. When real yields are high because growth is strong, higher earnings expectations support multiples. When inflation expectations are high, investors can rationally accept a thinner premium, since equities offer better protection against inflation than nominal bonds.
Nor has the equity market ignored bonds. Forward earnings for the S&P 500 have risen by close to 30% this year whilst the index has risen by about 13%, pulling the forward price-earnings multiple down to around 19x. The seven largest US companies trade at around 23x, and smaller companies have de-rated further. The adjustment is under way, masked by exceptional earnings growth. A thin premium does not force a correction, but it removes the margin for error should earnings disappoint.
The real risk: a term premium shock
The exception is a rise in yields driven by the term premium rather than by growth or inflation. Long-term rates then rise because investors are less willing to hold long bonds, yet nothing on the other side of the ledger improves. Everything priced off the long end bears the cost, including the long-dated issuance now funding AI capital expenditure, and business investment tends to adjust first.
Central banks cannot easily offset this without risking a further loss of confidence, and the fiscal arithmetic becomes self-reinforcing. For equities, discount rates rise with no offsetting improvement in earnings, hitting the long-duration growth stocks that have led this cycle hardest. The correlation between bond and equity returns turns positive, as in 2022, removing the diversification on which multi-asset portfolios rely.
Growth, not fiscal stress
Higher real yields, stable inflation breakevens and continued strong demand for credit all point to growth as the most plausible driver of this summer’s rise in yields. That is why equities have held up: the largest companies are partly insulated from the cost of debt, the consumer channel is slow and cushioned by interest income and record wealth, and earnings growth has offset the valuation adjustment. Smaller and more indebted companies, private credit, lower-income consumers and governments are feeling the strain, and each grows more exposed the longer yields stay high.
Saranac positioning
Equity exposure within our multi-asset portfolios remains modest but has been increased through the year. We hold limited exposure to the most richly valued parts of the market, where valuations offer little safety margin should earnings disappoint as bond yields rise. Fixed income exposure is lower than a year ago, and within it we favour high quality, short duration credit, where current yields can absorb some further increase in rates. A more diversified allocation has merits, and we hold above-average allocations to hedge funds, commodities and structured products.
Read the October Outlook here.
This commentary is intended for information purposes only. It does not constitute a personal recommendation, financial promotion, or regulated advice. Past performance is not a guide to future returns. All views are those of Saranac Partners and are subject to change.
