Episode summary
The Tension Between Equities and Bonds
Thoughts on the Market (Morgan Stanley)
· · 5 min · Hosts: Andrew Sheets
Summary
Rising Treasury yields have not derailed equities because profits have been growing fast enough to offset the pressure on valuations. Andrew Sheets says the benchmark US 10-year Treasury yield is up about 100 basis points this year, yet global equities are still up about 13%, creating an apparent contradiction that is resolved by stronger earnings.
He frames stock valuation through a dividend discount or Gordon growth model: higher required returns from rising rates lower valuations, but faster growth raises them. In his view, the recent surge in corporate profits has mattered more than the rise in rates. S&P 500 profits are up about 30% over the last year, median-company earnings growth is still in the mid-teens, and Europe, Asia, and emerging markets have also seen historically strong growth.
Sheets also argues that markets are not showing a broad rotation out of stocks and into bonds. He says flows still show money moving into both, and companies—especially those funding the AI buildout—may still prefer issuing debt at current yields rather than selling stock. The main implication for investors is that stronger growth can support equities even when rates rise, but higher yields leave less room for earnings disappointments.
Key takeaways
- Andrew Sheets says the US 10-year Treasury yield is up about 100 basis points this year even as global equities have gained about 13%.
- He argues that stronger earnings growth is offsetting valuation pressure from higher rates, with S&P 500 profits up about 30% over the last year.
- Sheets says the equity risk premium has stayed pretty stable year-to-date, despite the rise in bond yields.
- He sees no clear evidence that investors are selling stocks to buy bonds, since tracked flows still show money going into both markets.
- Companies funding AI spending may still find debt issuance attractive even at higher yields, according to Sheets.
- He warns that higher yields raise the bar for equities because they leave less room for earnings disappointment.
Notable quotes
“The benchmark US 10-year Treasury yield has risen about 100 basis points this year. Global equities at the same time are up about 13%”
“What we're referring to here is what we would call a dividend discount model or a Gordon growth model”
“corporate profits are growing quickly. Over the last year, profits for the S&P 500 are up about 30%”
“The valuation of the equity market, the PE ratio, has fallen significantly as yields have risen. But because earnings have risen so much more, stocks are still higher”
“Those profits need to keep growing quickly”
How the episode opens
Welcome to Thoughts on the Market. I'm Andrew Sheets, global head of fixed income research at Morgan Stanley. Today, thinking about equity resilience in the face of rising bond yields.
It's Friday, October 2nd at 2 p.m. in London. The benchmark US 10-year Treasury yield has risen about 100 basis points this year.
Global equities at the same time are up about 13%. And those two facts sit in uncomfortable tension. After all, higher bond yields give investors better return options elsewhere, and they also make future corporate profits worth less today, which in theory should push stock prices lower.
But there's a wrinkle here. That valuation theory actually has two moving parts. What we're referring to here is what we would call a dividend discount model or a Gordon growth model where the value of a company today is worth the value of its dividends divided by the difference of its required rate of return and its growth rate.
The higher the required rate of return, which interest rates push up, hurts a stock valuation. It increases the denominator. But a higher growth rate, well, that works in the opposite direction.
that decreases the denominator. It makes the company worth more. Hopefully, this is intuitive.
If a company has to meet a higher return hurdle, it will be worth less today. If a company's growing faster, all else equal, it's worth more. And that, we think, goes a long way to actually explain what's going on in markets today because corporate profits are growing quickly.
Over the last year, profits for the S&P 500 are up about 30% and the earnings growth for the median company. Well, that's still up in the mid- teens. Growth in Europe, Asia, and emerging markets have also been historically strong.
Indeed, if you told me on January 1st that the S&P 500 would be up about 13%.
From the episode’s captions: roughly the first two minutes, lightly cleaned. Keep watching on YouTube →
Topics
- equity valuations
- bond yields
- earnings growth
- dividend discount model
- investor appetite
Companies and tickers mentioned
- MS
- Morgan Stanley
Watch the episode
Watch “The Tension Between Equities and Bonds” on YouTube
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