Impact of Higher Yields On Growth and Equities

Cross-Asset Strategy and US Economics | North America

Impact of Higher Yields On

Growth and Equities

Key Takeaways

The macro cost from higher yields is real — we find a 100bp term premium shock trims 1.5–2.0pp from US GDP over eight quarters (we simulate a permanent shock that is not offset by monetary policy).

For equities, if nominal rates are driven higher by growth and inflation expectations, valuations can mostly stay intact, with multiples only dipping and ERP staying compressed.

AI-driven earnings keep equity valuations largely rate-indifferent this cycle. Risks to watch: negative earnings revisions and term-premium-led yield rises that hit growth significantly.

We prefer global equities over core fixed income in our base case; strong earnings and durable valuations support equity outperformance vs bonds in a multi-asset policy' scenario - see inside for details on our four simulated scenarios.

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US Economics: Higher yields, greater headwinds

Michael Gapen, Lingdi Xu

In recent months, the US economy has seen higher interest rates in the form of higher Treasury yields across the curve. Since March, the yields on the 2y, 5y, and 10y US Treasury notes are up over 140bp, 130bp, and 100bp respectively. The increase has come mainly in the form of higher real yields. An increase in Treasury yields raises borrowing costs for households and businesses, weighs on interest-sensitive spending, and can ultimately affect labor-market conditions and inflation. A number of factors are likely behind the rise in yields, including growth expectations driven by ever-increasing hyperscaler capex, increased corporate issuance to finance AI-related spending, rising energy prices from the ongoing conflict in the Middle East, tighter monetary policy, and the US deficit profile, among other items.

Simulating the effects of higher yields

To illustrate the effect of higher interest rates on the US economy, we use the Federal Reserve’s FRBUS model to simulate a 100bp increase in the term premium on the 5y, 10y, and 30y Treasury yield. The exercise provides a useful benchmark for tracing how a tightening in financial conditions through higher long-term real rates propagates through output, business investment, inflation, and unemployment. We choose a 100bp shock to broadly capture the effects of recent yield moves with the understanding that results can be linearly scaled up or down within a reasonable range to capture the effects of larger or smaller moves.

Conceptually, the magnitude of the effect breaks down along two dimensions: whether the shock to the term premium is permanent or temporary, and whether monetary policy responds to the rise in the term premium. In our simulations, between half and two-thirds of the shock to the term premium wears off after eight quarters, with the former occurring when monetary policy leans against the shock and the latter coming under unchanged monetary policy. Not surprisingly, economic costs are highest when the shock to the term premium is permanent and monetary policy is unchanged.

1. Temporary shock, endogenous monetary policy response. If the shock to the term premium is temporary and monetary policy endogenously responds, the damage to economic activity is limited. The shock reduces the level of GDP by about 1.2pp versus the baseline with no shock after eight quarters. The level of real business fixed investment, which tends to be more cyclical than GDP, is about 3.0pp lower after eight quarters. The annual rate of PCE inflation falls only about 0.06pp and the unemployment rate is 0.5pp higher than in the baseline. The shock to the economy is cushioned since the federal funds rate falls roughly 75bp, albeit with a lag.

2. Temporary shock, no change in monetary policy. If we constrain monetary policy from responding – indeed, expectations for monetary policy are cited as one factor behind the rise in term premia – then the level of GDP falls by about 1.6pp from a transitory shock to the term premium and real business fixed investment is 4.0pp lower. The annual rate of inflation falls by 0.1pp while the unemployment rate rises 0.7pp.

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3. Permanent shock, endogenous monetary policy response. If the shock to long-run term premia is permanent, and monetary policy is allowed to respond, then the level of GDP falls by 1.6pp relative to the baseline after eight quarters and real business fixed investment is down 3.9%. The annual rate of inflation declines by 0.1% and the unemployment rate is up 0.7-0.8pp. The federal funds rate falls 100bp. On net, the behavior of the economy in this scenario is very similar to that under a temporary shock, but monetary policy is constrained. We view these two scenarios as largely interchangeable.

4. Permanent shock, no change in monetary policy. Finally, if the shock to the term premium is permanent and monetary policy does not respond, then the level of real GDP and business fixed investment are down 2.1pp and 4.9pp, respectively. Annual inflation falls by 0.1-0.2pp amid a 1pp increase in the unemployment rate. We show the results of this simulation in Exhibit 2 to Exhibit 5 .

On net, we view scenarios 2 and 4 as fairly representative of the current environment, where term premiums on long-term Treasury rates have risen and monetary policy, in our view, is unlikely to respond by leaning against the wind. This points to a level of GDP that would be between 1.5-2.0pp lower after eight quarters, annual inflation that is down between 0.1-0.2pp all else equal, and an unemployment rate that is 0.7-1.0pp higher than in the baseline without a 100bp shock to 5y, 10y, and 30y term premia.

Caveats

As with any simulation, there are caveats. First, if the shock to yields is more temporary or monetary policy provides some offset from actual or expected behavior, then the growth effects would likely be smaller. Second, a key transmission channel of higher interest rates to softer real GDP and weaker labor markets is through business spending. If AI renders a large portion of business spending immune to any rise in interest rates, then simulated economic effects will overstate the results. Third, the FRBUS model would likely assume weaker equity valuations and lower home prices from higher interest rates. To what degree this would happen in an economy where AI is supporting the earnings outlook and the housing market is already stuck remains an open question.

There is also the simulation exercise itself. These simulations should not be interpreted as the unconditional effect of a 100bp increase in Treasury yields. Long-term interest rates are endogenous and can rise for a variety of reasons, some of which we identified above and each of which has its own implications for the economic outlook. By shocking the term premium, the FRBUS exercise instead isolates the marginal effect of an exogenous tightening in long-term financial conditions, holding underlying macroeconomic conditions fixed. The simulated decline in activity therefore represents the headwind from higher borrowing costs relative to a counterfactual in which those costs had not risen, rather than a prediction that an observed 100bp increase in yields will cause GDP to fall by the simulated amount.

Notwithstanding these caveats, we think the exercise above represents a reasonable starting point for discussion.

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On Higher Yields and Risk Asset Valuations

Serena Tang, Erika Singh-Cundy

As global yields have climbed to levels not seen in decades, it's revived a well-trodden market debate: at what point do higher yields become a headwind for equity valuations? We first wrote about this back in May, arguing that while multiples have some tendency to dip when yields are past a certain point, the relationship is weak. We now revisit that analysis through the lens of the equity risk premium, to assess whether higher rates have material implications for stock-bond relative performance.

The equity risk premium (ERP) – the compensation investors receive for holding stocks, over and above bonds – has been compressed in recent years, even briefly dipping into negative territory in late 2024 for the US. This is explained, in part, by rich stock valuations, which have remained in the upper end of their distribution largely due to the narrative of hyperscaler capex and AI adoption. Of course, higher rates have also contributed, as inflation has remained sticky in the post-pandemic environment.

With global yields on the rise again, market attention has turned to the interaction between bonds and equities, or more specifically: at what point do higher rates 'break' equity valuations? It may come as a surprise to some, but global and US ERP tends to stay compressed when nominal yields rise; in fact, once 10Y yields move past 5%, ERP has been negative on average (albeit on a limited number of observations). Over the last 25 years, nominal yields at or above today's levels have generally not forced a multiple derating – and because earnings yields rose less than bond yields, ERP stayed compressed. In short, the market can tolerate tight ERP even in rising-rate episodes, and already-rich stocks can stay rich relative to bonds.

Idea here as S&P 500 earnings yield – UST 10Y nominal yield. We show monthly data since 2001. Error bars show +/- 1 SD within each bucket.

here as MSCI ACWI earnings yield – UST 10Y nominal yield. We show monthly data since 2001. Error bars show +/- 1 SD within each bucket.

But does what is driving yields higher matter for whether equity valuations get derailed? The short answer is 'most of the time, not really'. If nominal yields are elevated because real yields are high, it tends to be under a backdrop of stronger growth. In this case, higher real earnings growth expectations reprice multiples higher, leading to a lower earnings yield, which in turn leads to ERP remaining low. If yields are elevated because inflation expectations are high, then multiples may hold and earnings yield stays flat, but rising rates would narrow the gap between the two, which also means ERP can stay compressed. But also think about this intuitively - if the market's main concern is inflation, then investors should be willing to be compensated less for holding the asset that offers better protection against inflation. While swings in yields and inflation expectations can be short-term headwinds to equities, they are not the largest headwinds to valuations.

Idea here as S&P 500 earnings yield – UST 10Y nominal yield. We show monthly data since 2001. Error bars show +/- 1 SD within each bucket.

here as MSCI ACWI earnings yield – UST 10Y nominal yield. We show monthly data since 2001. Error bars show +/- 1 SD within each bucket.

The question then is what if higher real yields are driven not so much by growth expectations, but term premium - could that be what breaks stock valuations? As our economist colleagues have discussed in the previous section, shocks to the term premium lower real growth over the following quarters, sometimes potentially quite significantly (see US Economics: Higher yields, greater headwinds ). In this case, the usual logic of higher rates coinciding with higher earnings growth and higher equity valuations falls apart, and there's no reason ERP should stay compressed. This is a near-term risk our Chief US Equity Strategist Mike Wilson has flagged: if yields break higher for non-growth reasons, stocks could wobble, and with a thin ERP cushion that could open the door to a modest 5-10% index pullback.

However, this cycle has been unique in that one of the largest marginal drivers of earnings– AI-related capex– has been and will continue to be largely indifferent to the rate environment. Morgan Stanley estimates ~US$1.5tr of hyperscaler capex in 2027, and another ~US$1.6tr in 2028. While the size of these capex needs has led to a high volume of issuance in the fixed income market, a technical that has driven up spreads, for equity markets, the phenomenon just means more robust earnings growth and high valuations, even if it may be somewhat divorced from economic growth. That earnings strength keeps

Idea valuations rich and earnings yields low, so earnings yield doesn't rise to meet higher bond yields and ERP stays contained even if discount rates climb. In fact, our US equity strategy team's S&P 500 target of 8,300 by mid-2027 already assumes almost all of the gain comes from earnings growth – AI plus a broader earnings recovery – rather than PE expansion. This provides another reason why higher yields today may not impact equity valuations much – markets are more than just the macro. But of course, this requires the assumption that the potential growth hit won't derail AI capex or adoption significantly.

All of this means we continue to prefer global equities over core fixed income in our global asset allocation. A renewed surge in oil prices and rates breaking through psychological levels could be headwinds in the near-term, but we push back against the idea that higher rates will be the brake for the structural equities bull market now. Strong earnings expectations and equity valuations that can stay intact mean global stocks can still outperform in a multi-asset portfolio.

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Stock Rating

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Category Overweight/Buy

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48%

29%

767

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770

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0%

33%

0%

10%

17%

216

12%

1754

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