Rising yields may eventually hurt equities


Investors have welcomed a recent rise in bond yields in advanced economies as a sign of recovery that should boost stocks, but if yields go much higher too quickly, equities could start to look unattractive.

The scale, as well as the speed of the yield rise is key. Too rapid an increase in yields would threaten a repeat of the market crash seen in 1994, when stocks suffered a 10 percent sell-off as bond yields rallied.

For much of the past 13 years, gradually rising bond yields have been positive for stocks as they reflect better economic prospects. But in late June that relationship broke down for the first time in 2-1/2 years as volatility in bond markets soared with rising U.S. Treasury yields.

Societe Generale reckons stocks in developed markets, where much of the money printing that depressed yields took place, can withstand a further rise in yields of around 140 basis points.

This is how its calculation works. Currently, equities are largely under-bought because investors see them as risky and demand a high reward to own them.

The picture is reflected in an unusually high equity risk premium – the excess return that investors require to hold stocks over risk-free bonds. In developed markets, the risk premium currently stands at 5.3 percent, or 530 basis points, well above the long-term average of 3.9 percent.

It would take a yield rise of more than 140 basis points to push the risk premium below its long-term average – at which point bonds would start to look more attractive than shares.

Applying a similar model, U.S. equities can absorb a rise of around 120 bps in benchmark yields, while the Japanese market has a larger wiggle room of 207 bps.

But in order not to spook investors, the shift in yields must be gradual.

“Given the current earnings growth expectations, for the equity risk premium to normalise, yield has to go up,” said Roland Kaloyan, asset allocation strategist at Societe Generale. “But it’s not just the normalisation in yields itself that counts, but also the speed of the normalisation.”

In emerging markets, yields can rise another 170 bps before the equity risk premium falls below the long-term average. China has a comfortable 363 bps of room, while India, where a yield rise of just 26 bps would be enough to tip the balance, appears to be the most vulnerable.

Ewen Cameron Watt, chief investment strategist at BlackRock Investment Institute, believes the market can run with a risk premium of 3-4 percent before equities become too expensive.

“Real yields in equities at the moment are probably 2-2.5 percent with 5-10 percent dividend growth. You only take three to four years to get to running 4 percent real yields through that growth rate,” he said.

Normally, rising yields reflect a rosy economic picture. Since 2000, U.S. equity returns were positive in 71 percent of the months with rising U.S. bond yields, according to Deutsche Asset & Wealth Management.

But the recent rise in volatility – a sign in markets of insecurity and uncertainty about the future – may have soured that relationship.

Bank of America Merrill Lynch’s Option Volatility Estimate (MOVE) index, which measures implied one-month volatility in U.S. Treasuries, more than doubled to hit a two-year high as yields raced to 2.7360 percent earlier this month.

Prior to that, U.S. yields moved to 2.66 percent from 2.16 percent in four trading sessions in June.

“That leg caused wobbles in the equity markets and gave the folks fears of another 1994-style scenario,” said John Bilton, European investment strategist at Bank of America Merrill Lynch.

In early 1994, U.S. yields rose 150 bps in the matter of four weeks or so, sending the S&P 500 stock index down 10 percent in the process. The move came after a build-up of inflationary pressures prompted a surprise Federal Reserve interest rate hike.

While the volatility spike is similar, the economic situation today is a little bit different. Inflation remains benign and the Fed has repeatedly said its plan to scale back its monetary stimulus depends on the economic recovery, and that monetary policy will remain loose for the foreseeable future.

“Riskless rates can rise much more quickly than the equity risk premium can contract,” said Bilton. “Equity markets can absorb a gradual rise in yields. But it’s the pace that can be destabilising.”

© Thomson Reuters 2013

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