Having unveiled its bearish 2018 outlook back in November, one which correctly predicted last week's short-vol implosion, S.G. has been turning increasingly more bearish on all asset classes as time went by: and not just stocks, but also bonds.
In a note to clients from S.G.'s B. R.-Hidden, the strategist writes that "The bear market in rates has started, and with it credit, and eventually emerging markets, should both come under pressure," echoing what Goldman said on Friday: "There has been a regime shift in the market, which implies further increases in yields."
And with S.G. telling clients they can no longer bet on "dormant" inflation to allow the pursuit of yield in virtually all rates products, the bank is advising clients to take "defensive" positions in short-dated debt, inflation-linked notes and Japanese government securities. Such a risk-averse move, will be worth it in the long run, SocGen claims, even if it means sacrificing income now.
"The key for fixed income portfolio investors from here to the summer should be avoiding capital losses. A loss of running yield is an acceptable price to pay."
In terms of geographical preferences, or rather the opposite, S.G. is "most wary of" and least exposed to core European sovereign markets poised for steeper repricing, according to Bloomberg.
Meanwhile, in a separate note from S.G.'s head of global equity strategy, A.n Bokozba, the bank outlines its proprietary risk premium for 27 developed and 23 emerging markets, and concludes that "a 10Y TSY yield of 3% will send the S&P 500 sliding below 2,500."
S.G. also highlights the scenario of a UST yield at 3% and an ERP of between 2.75% and 3%, in which the S&P can remain in a 2,300 to 2,500 range.
Continuing the recent theme of skepticism, S.G. urges clients to "be ready for the end of the goldilocks scenario"
Characterised by ample liquidity, low volatility, low bond yields and low inflation, the 'goldilocks scenario' masked the rich valuations of risk assets (RPIP-Jan 2018). With bond yields rising, we analyse the ability of US equities to absorb higher bond yields. We also look at the implications for asset allocation of higher bond yields and higher volatility."
This brings us to the key question: can the US equity market absorb higher bond yields? In response, the French bank calculates that at 2.8%, the equity risk premium (ERP) is significantly below its 3.9% long-term average. Over the last few months, an improving earnings growth outlook has helped equities absorb bond yields.
S.G. also looks at relative valuations, and notes that US equity has rarely been this expensive on an absolute basis as well as relative to USTs.
Cost of equity (a measure of absolute return from equity, currently at 5.6%) is significantly below its long-term average (8.6%). The US equity risk premium (excess return offered by equities over the risk-free rate, currently at 2.8%) is now below one standard deviation below the long-term average. Historically, investing at such low ERPs has delivered low single-digit annualised return in the subsequent five-year period.
As a result, with the equity risk premium approaching levels last seen during the dotcom era, any further rise in the 10y government bond yield to 3% would put pressure on the equity market to adjust lower. Historically, periods with such low levels of ERP have been led to low returns in subsequent years.
Ultimately, it's all about the equity risk premium:
If the equity risk premium is high (above average), a higher bond yield can be absorbed by the equity market. However, when the equity risk premium is already very low, the equity market's ability to absorb a higher yield is limited. Over the last few months, we have seen higher bond yields, but US equities remained well supported due to an improving earnings profile.
The problem is that even with last week's equity swoon, equities remain very rich; this rich valuation means US equity cannot absorb higher bond yields.
Our risk premium tools allow us to calculate an equilibrium index level for various scenarios of equity risk premiums and bond yields. A higher bond yield means the equity risk premium will decline and the relative valuation of equities becomes richer. dGiven an extremely rich relative equity valuation, a further rise in the bond yield would require equity markets to adjust lower to maintain the same ERP.
S.G.'s bottom line:
with ERP remaining the same, a UST yield of 3% could trigger an equity market correction. Under our base-case scenario, where UST yields rise to 3% (with ERP remaining the same), the S&P 500 falls to ~2500, which is our 2018 year-end target for the S&P 500.
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