Markets Brief: Here’s How High Yields Could Trip Up the Bull Market

There are just a couple of weeks left in the third quarter, and when it comes to scheduled news, there isn’t much on the calendar. That leaves investors to chew on the current set of knowns and unknowns: rising oil prices and the inflation outlook, rising bond yields, and the pace of the artificial intelligence buildout. Barring a surprise development, stocks could continue in a holding pattern until October brings the next batch of major economic news and third-quarter earnings reports.

In this week’s Markets Brief:

• Rising bond yields may be good for investors looking to generate more income from a portfolio, but they mean higher borrowing costs for companies. At what point could this be an issue for the economy and the market?
• The data center buildout continues, even amid growing opposition and, increasingly, bipartisan backlash ahead of November’s election. Morningstar DBRS analysts take a look at the demand outlook for HVAC systems, an element in data center construction needed to keep all those processors cool.
• The Securities and Exchange Commission continues to chip away at the ability for activist shareholders—and shareholders in general—to file corporate governance proxy ballot measures. We look at what some investors have to say about the SEC’s latest proposal.

Costlier Capital and the Stock Market

While the interest rate hikes by some of the world’s most important central banks came as no surprise these past two weeks, they were all significant. The Federal Reserve, the European Central Bank, and the Bank of Japan each raised rates by a quarter point. The Bank of England held steady, but it may just be a matter of time. In the bond market, long-term bond yields are at multidecade highs. The US Treasury 10-year note rose above 5%. As we’ve reported, a combination of forces drives the trend: stubborn inflation, strong economic growth, high government deficits, and massive demand to raise money for the artificial intelligence buildout.

This rise in bond yields translates to a higher cost of capital for businesses when it comes to raising money and investing in growth. “We’re in a rising cost of capital world,” says Jurrien Timmer, director of global macro at Fidelity Investments. Timmer sees this as a regime change, but one that isn’t entirely new. Instead, the global economy is heading back to the kinds of dynamics that existed before the 2008 financial crisis, he says. “We’re back to the ‘old normal.’”

Timmer says that rising interest rate impacts are already showing up in the stock market as one driver of restrained multiples.

But with solid earnings growth and a healthy economy, the bull market has not been tripped up. When could higher rates pose a more significant problem to the economy and the stock market? “If there was a tipping point where real yields are rising faster than real growth, or real growth is falling and real yields are above it or rising, that’s when the squeeze happens, and that’s when you start getting down a more problematic slope of debt unsustainability and things like that,” he says. For now, the US economy is growing at a rate above that of the real 10-year yield—the yield minus the rate of inflation—of roughly 2.6%. “So we’re not there yet,” Timmer says.

Whether this tipping point does or does not occur comes back, as a lot of things do these days, to the impact that AI has on the economy, here’s more from Timmer:

‘When you look at potential growth, it comes from two places. One is labor force growth, and that’s not growing very much right now. And the other one is productivity growth. And of course, the great hope is that this AI boom is going to create a productivity miracle. Hopefully, it doesn’t come at a great cost in terms of employment, but if productivity growth accelerates, that would increase the noninflationary speed limit.”

Keeping AI Cool and the HVAC Boom

The AI “picks-and-shovels” trade has spread far beyond technology stocks, reaching all the way into the world of commercial HVAC companies. Data centers’ enormous cooling needs are expected to drive robust growth in the HVAC industry through 2027, credit analysts at Morningstar DBRS find in a new report. That’s true even as the scope of AI borrowing is coming under intense scrutiny by investors.

“The scale and persistence of data center investment are creating one of the strongest demand environments the commercial HVAC industry has seen in years,” says Roco Pena, assistant vice president, corporate ratings at Morningstar DBRS.

The industry’s major players—including Carrier Global Corporation CARR, Trane Technologies TT, and Johnson Controls International JCI—are all expected to benefit. Orders outpace revenue, creating a backlog of demand that the analysts expect to persist into next year. That backlog means that investors have strong visibility into the firms’ likely cash flows in the months ahead. A steady stream of new equipment orders should also generate more consistent revenue over time since that equipment needs to be maintained.

The biggest risk for these firms, DBRS analysts say, will be making sure those backlogs of orders translate into real sales. At the same time, investors should expect some variability in revenue each quarter thanks to a few factors, including supply chain constraints and customer construction schedules.

Overall, the analysts see the data center buildout as positive for credit conditions in the industry.

The SEC and Shareholder Proposals: A ‘Chaotic’ New Approach?

For decades, the SEC has overseen a key process by which shareholders talk to management—the shareholder proposal, which goes on the proxy ballot for other investors to approve or reject. Under an 84-year-old rule, shareholder proposals led to developments such as independent board directors, annual elections for boards, and advisory votes on executive compensation.

Now, the SEC wants to roll that back. It wants the states, not the federal government, to decide whether companies should include shareholder proposals on proxy statements.

If the SEC adopts its plan, shareholders are concerned that states have no uniform regulations and shareholders would lose their uniform right to have proposals included. Foisting the duties onto the states would “create a patchwork and chaotic approach lacking in the uniformity on which both companies and shareholders rely,” Beth-Ann Roth, general counsel of the Interfaith Center on Corporate Responsibility, said in a statement.

The SEC’s proposal “has tilted the field strongly in favor of shielding management from shareholder input … creating a byzantine and difficult process which favors shareholder votes going to support management,” Danielle Fugere, president of shareholder advocate As You Sow, said in a statement.

What happens now? The SEC will make its final rule after a 60-day comment period. If it gets enacted, investors will likely pay closer attention to the director elections and approval for pay packages that feature regularly on proxy statements, says Jackie Cook, senior director, stewardship for Morningstar Sustainalytics. “Issues that may otherwise have been directly addressed on proxy ballots may be indirectly addressed if shareholders believe that board oversight is lacking or management’s incentives are misaligned,” Cook says.