The reflation trade – investors betting on a broad-based global economic recovery – continues to gain momentum. Investor attention is starting to fix most firmly on one indicator of this economic recovery – the rise in government bond yields. US yields in particular are hitting new highs on almost a weekly basis (last week touched a high of 1.33%) and the yield spread (the higher the spread the stronger the expected economic recovery) is at multi-year highs.

Deze stijging geldt niet alleen voor Amerikaanse staatsobligaties. Wereldwijd stijgen de rentes op staatsobligaties waarbij zelfs die van Duitsland niet achter blijft.

It is important to note that stock prices and bond yields can and often do increase simultaneously as a reflection of stronger economic activity – particularly in the early stages of any recovery. The risk to financial assets occurs when the speed of the rise in yields indicates an increasing inflation worry and central banks themselves make it clear that they are ready and willing to stop it. In short, higher interest rates increase the risk in equity markets but are not yet at a level that should destroy performance given the surplus liquidity awash in global markets.

That said, higher rates could be a headwind for the popular Growth stocks whose terminal values are being discounted by zero or even negative long-term rates. To date, the market advance has been extremely broad-based with the only laggards being the more defensive sectors – Staples, Healthcare, Utilities, and Telecom. Investors have been willing to ignore stretched valuations in the Growth darlings as long as interest rates remained at zero. As rates rise and economic growth becomes more diffuse, we habour strong doubts as to the ability of the Growth stocks to avoid a meaningful contraction in valuation metrics. As the chart below shows, Value stocks are expected to significantly outperform Growth stocks in terms of earnings over the next two years. The performance of Value stocks has certainly improved but their valuations are at historical lows relative to Growth which remains incongruent with the expected path of earnings.

The extended period of Growth outperformance has increased the valuation risk of many equity indices. The chart below is often referred to as the “Buffet Indicator” as it is a valuation metric to which he has made reference to in the past. If Buffet still believes in the value of this indicator, it may explain why he has struggled to deploy the > $140 billion sitting on the balance sheet of Berkshire Hathaway. On this measure the market is more stretched than at its prior peak in 1999.

Skeptics will argue that with 40% of S&P earnings coming from outside the US, this valuation metric is no longer useful. Maybe so, but again the adjusted chart below shows we remain at elevated valuation levels whatever the chosen measure.

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