Think 5% Yields Will Crush Stock Market? Goldman Sachs Says Think Again

Goldman Sachs is challenging the prevailing view that 5% Treasury yields pose a threat to equities, citing a lack of historical correlation between nominal Treasury yields and S&P 500 returns; instead, they argue that real, inflation-adjusted Treasury yields are the more relevant comparison, and that equities remain attractive given the current spread between the S&P 500 earnings yield and real Treasury yields. Goldman Sachs' rates strategist, George Cole, anticipates yields will remain elevated due to factors like weak hedge demand, fiscal deficits, and shifting foreign appetite for U.S. debt.

Analysis

Goldman Sachs challenges the prevailing market concern that 5% nominal U.S. Treasury yields represent a critical breaking point for equities. Despite 30-year Treasury yields exceeding 4.9% and 10-year yields at 4.4%—driven by inflation expectations, Federal Reserve policy, a Moody's downgrade, reduced foreign buyer appetite, and fiscal spending concerns—Goldman's research indicates no consistent historical correlation between nominal Treasury yields and S&P 500 returns. Their analysis reveals that since 1940, median annual total equity returns remained robust even with significantly higher yields; for instance, when 10-year Treasury yields were between 5% and 6%, equity returns averaged 16%. Goldman Sachs posits that the more relevant comparison is the S&P 500 earnings yield (currently near 5%) versus the real, inflation-adjusted 10-year Treasury yield, a spread that currently favors equities by 260 basis points. Factors such as rising home-market yields and high hedging costs are disincentivizing non-U.S. investors from U.S. Treasuries, as highlighted by LPL Financial, contributing to the 2% year-to-date decline in the iShares 20+ Year Treasury Bond ETF (TLT), marking its fifth consecutive year of losses. Goldman's rates strategist, George Cole, anticipates yields will remain elevated due to structural issues including weak hedge demand, growing fiscal deficits, shifting foreign demand, and potential U.S. tax policy changes like Section 899 of the House fiscal bill, which could further dampen foreign interest in Treasuries.

Key Decisions for Investors

• Investors should consider Goldman Sachs' view that a 5% nominal Treasury yield may not automatically trigger an equity market downturn, and instead focus on the spread between equity earnings yields and real Treasury yields, which currently suggests relative attractiveness for stocks.
• Monitor real (inflation-adjusted) Treasury yields as a more pertinent indicator for equity valuation compared to nominal yields, as advocated by Goldman Sachs.
• Prepare for a period of sustained higher interest rates due to structural factors like fiscal deficits and evolving foreign demand for U.S. debt, which could impact fixed income allocations and valuations in rate-sensitive equity sectors.
• Given the persistent underperformance of long-duration bonds, exemplified by TLT's fifth consecutive year of losses and shifting global demand dynamics, investors should reassess the risk-reward profile of their U.S. Treasury holdings.