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

Interest rates may have a greater influence on economic growth expectations than on stock market valuations, as artificial intelligence tailwinds and structural shifts in investor behaviour weaken the traditional relationship between bond yields and equities, Citi analysts said.

The traditional allocation decision between stocks and bonds has been partly undermined by AI-driven fundamentals and changes in equity ownership, analysts said. While higher borrowing costs remain important for the economic outlook, their impact on stock market valuations and cross-asset flows has diminished over time.

Citi's proprietary fair value model, which starts with the 10-year U.S. Treasury yield and incorporates macroeconomic adjustments, puts the S&P 500's fair value range at 17.1 to 22.1 times earnings.

The index currently trades at 22.4 times, above that range, suggesting valuations reflect stretched sentiment and complacent investor positioning, analysts said.

The divergence across sectors also highlights the changing relationship between rates and equities. Cyclical and defensive stocks have declined since late August amid traditional interest-rate sensitivity, while growth stocks have proved more resilient on expectations of sustained AI-related earnings growth, Citi said.

Mixed economic indicators suggest the recent rise in yields may partly reflect expectations of additional government debt issuance rather than an overheating economy.

If higher rates are driven primarily by increased bond supply, investors may require different valuation levels before shifting capital from equities into fixed income, analysts said.

Structural changes in investment flows are also supporting equities. The shift from defined-benefit to defined-contribution pension plans, equity-heavy target-date funds favoured by younger investors, and growing foreign investment in stocks have weakened the traditional link between relative stock and bond valuations.

An entrenched equity culture may therefore continue to support markets despite elevated valuations. However, Citi said the trend raises a key question: who will provide the next incremental wave of equity demand?