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The spectre of higher inflation, interest rates and bond yields usually spells trouble for stocks. But Wall Street continues to scale new peaks, driven by the increasingly entrenched phenomenon of sub-zero real yields.

The inverse relationship between the fall in U.S. Treasury Inflation-Protected Securities’ ‘real’ yields to record lows and major U.S. equity indexes grinding to new highs has strengthened substantially in the last six months.

It has been one of the few constants as Wall Street has hurdled several obstacles it might normally stumble on: historically high inflation and inflation expectations; the Fed tapering and preparing to raise rates; spiking bond market volatility; flattening and even inverted yield curves.

Long-held priors about these relationships are being questioned, and the stakes could not be higher: U.S. inflation is the hottest in over 30 years, the Fed still thinks it is “transitory,” but pressure on policymakers is intensifying.

There are bumps in the road, but equity markets march on. Low long-term bond yields lower the discount rate that’s used to value companies’ future cash flows in today’s stock price - any backup in the discount rate redraws the map for equity along with the damage from related tightening of credit.

While real yields may push back higher as central banks prepare to tighten, few see them turning positive for a long time.

Gargi Chaudhuri, head of iShares investment strategy at Blackrock, says we are in a “new environment” in which the old assumptions that rising interest rates and nominal bond yields are bad for equities has to be challenged.

“More importantly for equities, real yields will become a problem if they enter restrictive territory,” she says, adding that this is unlikely to happen for two to three years.

Meghan Swiber, rates strategist at Bank of America, reckons 10-year real yields could remain negative for around 10 years. Analysts at Morgan Stanley published a similar forecast earlier this year.

Inflation-adjusted yields on TIPS have diverged from yields on conventional Treasury bonds in recent months. The difference between the two, the ‘breakeven’ rate and a closely-watched measure of inflation expectations, has risen sharply.

The fall in real yields is in some ways unsurprising, given the scramble from investors for inflation protection. In fixed income, TIPS and related investment vehicles such as TIPS exchange-traded funds, are in huge demand.

The 10-year U.S. TIPS yield has been deeply negative all year. After a notable rise at the end of the first quarter, it has slumped back, hitting a new low of -1.24% this week. Although still low by historical standards, the nominal 10-year yield has risen 65 basis points this year.

Strategists at Blackrock and Bank of America both say demand for TIPS ETFs has been “incredible,” from investors wanting a short-term inflation hedge and others adding inflation protection into their longer-term asset allocation strategy.

To the extent that real rates stay negative, growth remains above trend, consumer spending holds up and companies are able to pass on higher costs to their customers, equities could continue to perform reasonably well.

The S&P 500 has made 65 new all-time highs in calendar year 2021, the second most ever and only 12 away from the record of 77 set in 1995.

Third quarter earnings were solid: 80% of S&P 500 companies beat forecasts, with that rising to 93% for the tech sector. Valuations are still high, but don’t appear to be prohibitively so just yet.

Markets may be entering a critical period though if the Fed struggles to convince investors - and even itself - that it can wait until its taper schedule is over around the middle of next year before raising rates.

And TIPS are expensive. Can real yields really go any more negative? Maybe, if Britain is any guide. The 10-year inflation-linked gilt yield is below -3.0% and has been sub-zero for a decade.

Oliver Allen, markets economist at Capital Economics, believes real yields’ sway over Wall Street will gradually fade as elevated inflation forces the Fed to tighten policy in real terms.

“The tailwind of falling real yields turning into a modest headwind is one reason why we think U.S. equities will struggle to make gains over the next couple of years,” Allen says.

-- Jamie McGeever, Reuters

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Stocks to ponder

Intertape Polymer Group Inc. (ITP-T) This company develops and manufactures products such as carton sealing tapes and industrial and specialty tapes and fabrics, used in industrial, automotive, and aerospace applications. As Jennifer Dowty tells us, the stock has a healthy balance sheet, reasonable valuation, and a unanimous buy recommendation from nine analysts.

Rivian Automotive Inc. (RIVN-Q) This electric-vehicle maker that has been around for over a decade finally got around to delivering a product this year – 156 pickup trucks – and nearly all went to its employees. Despite that minuscule total, investors on Wednesday decided Rivian was in the same league as some of the most recognized names in the auto industry. In the first day of trading after its initial public offering, Rivian’s stock jumped 29 per cent, putting its market value at US$86-billion – in line with GM’s and higher than Ford’s. The New York Times looks at what’s behind all the fanfare.

The Rundown

Here’s why investors need to temper expectations for REIT returns

A secular decline in bond yields over the past three decades proved a huge advantage to income-based investment strategies, motivating asset flows toward distributions and dividend yields. Recent inflation fears, however, have thrown that trend in reverse. Scott Barlow explains why the outlook isn’t so bright for Real Estate Investment Trusts in particular.

TSX still has ‘room to run’ against its U.S. counterpart

If ever there was a year that should see the Canadian stock market trounce its U.S. counterpart, it is this year. Rising interest rates, persistent inflation, a burgeoning global economic boom, a run on commodity prices and a huge discount on Canadian stocks – all of it favours the Toronto Stock Exchange, in theory at least. And yet, the two markets are pretty much neck and neck. Tim Shufelt takes a look at why, and what may happen next.

Bargain hunting? Try some opportunities in ugly stocks

The stock market’s relentless rise in recent months has boosted the stock of any company with a pretty story to tell. Many equities are now unusually expensive. So where can bargain hunters turn for relief? Try ugly stocks. These are stocks operating in out-of-favour industries, with question marks around their futures. Their very real challenges mean they have largely sat out the market boom. However, their modest valuations also suggest they might be able to generate value for investors who don’t mind going where the crowd isn’t. Ian McGugan looks at some stocks that fit the bill.

Musk’s Tesla sales cause a stir, but billionaires sell stock all the time

If trading in the shares of Amazon, Microsoft, Facebook and other billionaire-owned companies is any indication, Tesla co-founder Elon Musk unloading part of his stake in the company may not be bad for the electric carmaker’s shares over the long term. David Randall of Reuters explains.

Why financial planners have an edge with millennials over investment advisers

Good luck to the investment advisers waiting for young adults to replenish a client base that now relies on boomers and older Canadians. For a bunch of reasons, millennials don’t seem destined to follow in their parents and grandparents in seeking investment help from advisers. The same reasons suggest a different path for young adults - one that focuses more on financial planning than selling and managing investments. Rob Carrick explains.

Bond market sees inflation spike subsiding, if not right away

Bond markets expect a surge in inflation underscored by U.S. retail prices data on Wednesday to abate even if price pressures worsen in the very near term, though investor opinions should vacillate amid divisions about how soon the Federal Reserve will act to choke off rising prices. Karen Brettell of Reuters explains.

Also see: Far from debasement, U.S. dollar hits overdrive

Others (for subscribers)

The highest-yielding stocks on the TSX, plus risk data

Gordon Pape: This royalty company has raised its dividend five times in the past year

Thursday’s analyst upgrades and downgrades

Friday’s analyst upgrades and downgrades

Friday’s Insider Report: CEO and COO are buyers of this dividend stock rebounding off of its 2021 low

Number Cruncher: These seven Canadian funds exposed to energy sector have low ESG risk

Number Cruncher: Five conglomerates in the spotlight after GE’s breakup

Globe Advisor

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Compiled by Globe Investor Staff