Citi says interest rates may matter more for economy than stock valuations

Citi analysts say interest rates now have a greater influence on economic growth expectations than on stock market valuations. They argue that artificial intelligence tailwinds and structural shifts in investor behavior have weakened the traditional relationship between bond yields and equities. This development partly undermines the standard allocation decision between stocks and bonds, as the impact of higher borrowing costs on cross-asset flows has diminished over time, even though those costs remain important for the economic outlook.

Citi's proprietary fair value model, which begins with the 10-year U.S. Treasury yield and incorporates macroeconomic adjustments, estimates the S&P 500's fair value range at 17.1 to 22.1 times earnings. The index currently trades at 22.4 times earnings, a level above that range. Citi analysts suggest these valuations reflect stretched sentiment and complacent investor positioning.

The changing relationship between rates and equities is evident in diverging sector performance. Cyclical and defensive stocks have declined since late August, displaying traditional interest-rate sensitivity. In contrast, growth stocks have proven more resilient, supported by expectations of sustained AI-related earnings growth. Citi notes that mixed economic indicators imply the recent yield increases might stem from anticipated additional government debt issuance instead of an overheating economy.

If higher rates are driven primarily by increased bond supply, Citi analysts say investors may require different valuation levels before shifting capital from equities into fixed income. Structural changes in investment flows are also supporting equities by weakening the traditional link between relative stock and bond valuations. These changes include the shift from defined-benefit to defined-contribution pension plans, the popularity of equity-heavy target-date funds among younger investors, and growing foreign investment in stocks.

Citi states that an entrenched equity culture may continue to support markets despite elevated valuations. However, the bank raises a key question about who will provide the next incremental wave of equity demand.