US 10-year yields pose bigger risk to equities than oil: Drew Pettit

Drew Pettit, Chief Investment Strategist at Roundhill Investments, says investors should be wary of risk assets if the US 10-year Treasury yield moves well into the 5% range. He sees 5.5% as the level where higher rates could start challenging the growth expectations that have supported equities, leaving little room for companies to miss earnings or lower guidance.

"The psychological barrier at 5% matters a lot for investors, but to us, I think it's around 5.5% where we really start getting worried that the growth expectations in the market won't be enough for investors to stay in equities longer term," he said.

Pettit also sees little clarity on when the US-Iran conflict will end and says markets are not pricing in a near-term resolution. Against this backdrop, he says Roundhill Investments is staying away from cyclicals and would rather buy secular growth, quality large-cap stocks and select AI stories where earnings estimates are moving higher.

This is an edited transcript of the interview.

Q: There's crude, bond markets, but let's begin with the US 10-year bond yield. 4.96%, the highest that we've seen since November 2023, and we're now approaching the 5% mark, which is often called the tipping point when it really starts to hurt. What's the global bond market telling you? Is it sending out a much bigger warning?

A: I think it's telling us to be a little bit wary of risk assets in the short term. When we think about this, the growth expectations in the US are really, really good for stocks. The problem is if we get that 10-year rate, let's say well into the fives, let's call it 5.3%, 5.4%, that doesn't leave any wiggle room for any company to really miss reports or talk down guidance.

So, the psychological barrier at 5% matters a lot for investors, but to us, I think it's around 5.5% where we really start getting worried that the growth expectations in the market won't be enough for investors to stay in equities longer term.

Q: I think it was just about three years back when the US bond yields were closer to 5.3%, and after that, they corrected and now started rising. But you're saying the red line in terms of bond yields would be a level of 5.5%. What about the US-Iran war, and the way it's been progressing now for the seventh month? It's broadening. Tankers are getting hit. It's escalating. There's far more aggression now, and despite all the narrative that we've heard about it easing, it hasn't. So, what is now your baseline assumption in terms of crude prices and how long this conflict is going to prolong?

A: This is an interesting one because I actually don't think it's as big of a deal to risk assets globally as rates are.

From a pricing perspective, not sure where crude's going to go short term. That's a little bit outside of my comfort zone. But I would say, from a market pricing perspective, we're more used to volatility in oil. When we're looking at oil implied volatility, that's reasonably high. So, people are hedging exposure there. They have mechanisms, they're doing that.

But when we look at rates, rate implied volatility is just starting to move higher. Yes, we're talking about rates that are breaking to highs we haven't seen for multiple years now, but investors are better prepared for that.

So, while we're concerned about Iran and how that hits inflation, not just in the US but globally, I think the bigger story is still interest rates because people really aren't prepared for a much higher break there.

More to come...

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