Freedom of Curtalis
The pressure on the stock market due to the rise in bond yields is increasing, as Bank of America points out. The actual performance of the American 10-year bond —the discount rate for global shares— has increased by 80 basis points since February, returning to its high cycle. In itself, a change in the yields of bonds would justify an adjustment in the valuation of European shares by around 11%.
However, at the initial stages of the decline in bond prices (and the corresponding rise in yields), the shares were protected from:
a) the shrinking of risk insurance premiums, which was fueled by the investment explosion in the field of artificial intelligence (AI) and hopes for a US-Iran peace agreement. The risk premium for European shares (ERP) declined from the high year of 5.2% in March to the low 24 years of 4.3% in August, almost completely compensating for the risk-free rate in the same period, and
b) the explosion of corporate profits, with market forecasts (consensus) for global profits per share (EPS) over a 12-month horizon rising by almost 20% since February, leading to an unusual excess of the profitability cycle compared to the course indicated by the dynamics of global growth.
Nevertheless, as the BofA points out, in recent weeks the resilience of the stock market has begun to show signs of fatigue, with the Stoxx 600 index recording a fall of nearly 4% since mid-August, as the continued rise in bond yields has been accompanied by an increase in the ERP by 20 basis points at 4.5%, while the strong upward review cycle began to slow down.
At sectoral level, the continued increase in bond yields boosted the continued overturning of the financial sector (with banks recording a 20% increase over the market since March) and the subversion of defence branches operating as bond proxies, such as the pharmaceutical sector (a 15% decrease over the market since March, with the relevant price index of the industry falling to a low of eight years) and the main consumer goods sector (a 10% decrease against the market since February).
What triggers the Sell-off on bonds
The actual yields of the bonds continue to follow the market's expectations regarding Fed's policy, suggesting that the fall in bond prices (and the consequent rise in yields) is mainly due to the adjustment of estimates for a more rigorous monetary policy ("hawkish" attitude) by the Fed, notes BofA.
This trend was powered by: (a) the strong dynamics of global growth, with the global PMI index reaching a high of three years in August· (b) improving the American labour market, and (c) increasing inflationary risks, as the new escalation of tension in the Middle East not only led to the price of oil again over $100 a barrel, but also contributed to the further burden of supply chains.
Where will it go? Sell-off on bonds?
The prevailing estimate predicts a further rise in bond yields, however BofA analysts specialising in interest rates have recently adopted a positive (bullish) stance on the duration (duration) of American bonds, appreciating that there is room for a reduction in the yield of the American 10-year bond to 4.5% by the end of the year as:
1) the market, at current levels, has already fully integrated three interest rate increases by 25 basis points from Fed to mid-2027
2) the conditions in the American labour market remain fragile, with the increase in employment on a rolling quarter remaining close to zero in July and the strong August data likely to be subject to negative revisions
3) inflation dynamics are not undoubtedly strong, as the consumer price index (IMF) quarter moves close to the low five years of 1.6% on an annual basis
4) the political timetable may be an obstacle to Fed's interest rate increases, as its October meeting takes place just a few days before the mid-election, resulting in, if the Fed does not proceed to an increase in September, unlikely to do so before December·
5) to the extent that the wave of liquidity on the bond market begins to negatively affect the shares, this trend will likely limit itself, as a wider risk-off shift of markets leading to stricter financial conditions would likely reduce Fed's disposal of aggressive monetary tightening, and (
(b) placing investors on the market is already strongly short, which increases the likelihood of a sharp rise in bond prices (and a corresponding fall in yields).
Why does he expect a dip?
BofA maintains a negative attitude towards European shares after the fall by 4% in the last month, which led the Stoxx 600 index to a low two-month period, while its macroeconomic estimates indicate a further fall of 9% by the beginning of next year.
A dampening of the pressure on returns, as its interest rate market analysts predict, would work supportively for the market.
However, BofA still considers market expectations to be too optimistic regarding the viability of the boom of investments in Artificial Intelligence: European and global expectations of the profit margin are at a historically high level. The projected complex global increase in profits per share (EPS) over the next three years amounts to a high of 15%+, a level usually achieved only during a recession recovery. The expected contribution to profits from technology is at record levels. And the market applies extremely strict risk premiums to these optimistic profit projections.
BofA points out that it sees ample room for market disappointment, especially given:
(a) the strong level of competition at the level of Artificial Intelligence models. High levels of competition, as he points out, may lead to reduced tariff power and therefore lower than expected profit margins. This is a classic phenomenon of failure that accompanies aggressive investment cycles and is a key reason why, historically, these cycles have often resulted in disappointment
(b) the increasing financing costs for hyperscalers, due to the expansion of their credit margins in response to the increasing borrowing needed to finance their investment costs·
(c) the risk of insufficient supply of electricity to meet the needs resulting from the planned increase in the capacity of data centres; and
(d) the increase in political risk, given the increasing political reactions to the construction of data centres. Any evidence of a slowdown in the explosion of investment costs in the AI sector, in response to these obstacles, is likely to lead to further expansion of risk insurance premiums —which are already low— As well as a deterioration in profitability expectations, BofA stresses. And the possibility of further escalation of the US-Iran conflict, although not its core scenario, would further strengthen arguments in favour of higher risk premium.
