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Sept. 27, 2022, 12:57 p.m. EDT

Why 2-year Treasury yields are ‘the base problem’ for the struggling stock market, according to this Morgan Stanley portfolio manager

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By Christine Idzelis

It’s going to be tough for the U.S. stock market to make much headway bouncing back from the bear market with two-year Treasury yields at or above 4%, according to Andrew Slimmon, an equity portfolio manager at Morgan Stanley Investment Management.

“It’s hard to convince investors to take risk when the two-year risk-free rate is north of 4%,” Slimmon said in a phone interview. “I think that’s going to continue to weigh on stocks until we see some reversal.” 

The yield on the two-year Treasury note has surged in recent weeks as investors anticipate further interest rate hikes from the Federal Reserve as it aims to rein in high inflation. Two-year yields rose Monday to 4.315% —  the highest since Aug. 14, 2007 based on 3 p.m. Eastern time levels, according to Dow Jones Market Data. That compares with 0.73% at the end of last year.

Typically, an average 35% of the S&P 500 index has a higher dividend yield than the 2-year Treasury note, according to Slimmon. But that portion is now much smaller at around 11%, he said. 

By comparison, about 20% of the S&P 500 typically provides a dividend yield above the 10-year rate, which is not that far off from the current percentage of about 18%, said Slimmon.

“I just don’t see the stock market getting out of this rut until you get relief on the short end of the yield curve because it’s very, very competitive,” he said, pointing to the broad S&P 500 index. 

The S&P 500 carved out a new 2022 low Monday, closing at 3,655.04, while the blue-chip gauge Dow Jones Industrial Average fell into bear-market territory, according to Dow Jones Market Data. So far this year, the S&P 500 is down 23.3% through Monday, while the Dow has dropped 19.5% over the same period, according to FactSet data.

Read: The Dow just joined the S&P 500 in a bear market: What investors need to know

The technology-heavy Nasdaq Composite is struggling with deeper losses in 2022, sinking about 31% through Monday, FactSet data show. 

But valuation multiples for the S&P 500 index have been propped up by big tech companies, with investors “hiding out” in some mega-cap stocks, according to Slimmon. “There are a lot of companies that are down significantly more than the market,” with some “enticing” opportunities in individual stocks, he said. 

One of the areas that Slimmon said he likes is beaten-down home-related stocks after consumer sentiment sank to an all-time low earlier this year based on the University of Michigan survey. 

The U.S. stock market was down in early afternoon trading Tuesday, with all three major benchmarks struggling to bounce after five straight days of losses. The Dow /zigman2/quotes/210598065/realtime DJIA -0.16% was trading 0.6% lower, while the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.20% fell 0.5% and the Nasdaq /zigman2/quotes/210598365/realtime COMP -0.07% slipped 0.2%, according to FactSet data, at last check. 

“I think the base problem for the stock market right now is that the two-year Treasury is a very competitive alternative to stocks,” said Slimmon.

The yield on the two-year Treasury note /zigman2/quotes/211347045/realtime BX:TMUBMUSD02Y +0.68% was down about two basis points Tuesday afternoon at 4.29%, FactSet data show, at last check. The 10-year Treasury yield /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.40% was meanwhile up 10 basis points at around 3.97%, after on Monday rising to its highest level since April 2010 based on 3 p.m. Eastern time levels tracked by Dow Jones Market Data. 

Two-yields may start to come down as the economy slows, potentially into a recession, as the result of the Fed aggressively tightening its monetary policy, or as inflation pressures show signs of easing, said Slimmon.

Also read: A surging U.S. dollar is creating an ‘untenable situation’ for the stock market, warns Morgan Stanley’s Wilson

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