JPMorgan sees ‘late-cycle vulnerabilities’ as US Treasury yields advance

The relentless rise in bond yields isn’t over and investors better prepare for less-than-stellar returns across asset classes, according to JPMorgan Chase & Co.

The 10-year US Treasury yield should rise steadily into late 2019 because the Federal Reserve will probably hike rates every quarter through the end of next year, strategists led by John Normand wrote in a note on Friday. Their target is 3.5% as of the third quarter of 2019.

“The bond market’s behaviour and its contagion are symptomatic of late-cycle dynamics that will ratchet-up market volatility over the next year, leading most markets but equities to keep underperforming cash,” the strategists wrote. “Late-cycle vulnerabilities abound in terms of fundamentals and valuations, so justify very low absolute and risk-adjusted return targets across assets.”

Normand also sees potential for 10-year yields at 4% or even 5% if certain factors occur, including:

An overshoot of the core personal-consumption expenditures data to something like 3%

A change in the Fed’s reaction function to a more dovish stance as inflation rises

A nonlinear response to the confluence of a faster Fed balance-sheet shrinkage and a higher federal budget deficit

US equities would be challenged by real cash rates in the range of 1% to 2% because that probably signifies a restrictive monetary policy setting that then weakens the economy and slows earnings growth, the strategists said.

Recent rate moves have overshot fundamentals by around 20 basis points, according to JPMorgan’s fair-value model. In addition, “no previous rate backup has simultaneously sunk the S&P 500, Russell 2000, cyclicals and value by such magnitudes,” the strategists said.

This rate sell-off is coming during “perhaps the most unhelpful macro context of the cycle,” Normand et al. said, citing Fed policy moving away from being highly accommodative, slowing global growth, a rising oil price on supply stress and the US-China trade war that could put stress on earnings guidance or profits themselves.

“If we’re right that the Fed hikes every quarter through 2019, real rates will enter the red zone just after mid-2019,” the strategists wrote. “For US 10-year yields, a real rate above 1.5%, which is about 50 basis points higher than current levels, would reduce the relative attractiveness of stocks by compressing the equity risk premium (inverse of P/E ratio) to its long-term average.”

Bonds and much of credit are expected to underperform cash, and equities will beat bonds by something like mid-single digits, JPMorgan said.

Those projections “will be unsatisfying to almost any investor, but such returns nonetheless seem realistic when the US economy is looking increasingly late- cycle,” the strategists wrote.