Back in early February, after the great volatility explosion which sent the VIX to 50, killed the XIV ETF and which we now know was precipitated by the market’s misreading of the sharp January rising average hourly earnings print (which just as we said at the time, was due to a drop in the workweek and little else as the latest BLS data revisions confirmed), Goldman’s clients wanted to know one thing: “how much worse will it get?” In response, Goldman’s chief equity strategist David Kostin answered “not much”, and indeed so far he has been proven correct as not only is the Nasdaq back to all time highs, but the S&P has recouped virtually all of its 10% correction.

One month later, with the market once again soaring, things are even more confusing because while the vol scare may have come and gone for now, two other risks remain, namely rising interest rates and the escalating trade conflict, both of which according to Goldman “have ended the “Goldilocks” environment of 2017.” And yet, as Citi lamented overnight, the markets remain oblivious.

Adding to this, a somewhat puzzled Kostin writes in his latest Weekly Kickstart, that “with 10-year Treasury yields now at 2.9% and new tariffs on steel and aluminum formally ordered this week, the ratio of return/realized volatility has declined from 3.3 in 2017 (22% / 7%) to 0.3 YTD. The S&P 500 nonetheless remains in positive territory.”

This confusion appears to be spreading, and has in turn prompted Goldman’s clients to ask, “where to from here?“

Kostin’s answer is two-fold, first focusing on the move higher in rates, and why there may be less to it than some bears insist:

Interest rates present a more substantial risk to equity valuations than they do to earnings. Because corporate borrow costs are historically low and interest coverage is still elevated, we estimate that a 100 bp increase in 10-year Treasury yields would reduce S&P 500 return on equity (“ROE”), excluding Financials, by less than 50 bp (from a current level of 19%). Financial earnings benefit from high rates, so the overall impact on S&P 500 profitability is surprisingly small.

The speed of rising interest rates poses a more immediate risk to equities than does the level of rates. This week we published an analysis of the relationship between bond yields, corporate growth, and equity valuations. One key observation from our analysis was that S&P 500 prices typically stop increasing when rates rise more quickly than a standard deviation in a month (currently equating to a rise in Treasury yields of roughly 20 bp), and equity prices decline when yields rise by more than two standard deviations (40 bp). This relationship has held true during the last 50 years irrespective of whether rising yields were driven by inflation or real rates.