The Outlook: November 2018 economic commentary

Commentary
 

Why are rising US bond yields unnerving equity markets?

The events of recent weeks have underlined the importance of the bond market for equity investors. The sharp falls in global stock markets seen in October, like those witnessed earlier in February, were triggered in part by a run-up in US government bond yields. So why've yields risen and why are equity investors starting to worry?

As we know, the yield on a government bond reflects a host of factors, including expectations for growth, inflation and the future path of interest rates. Moreover, in the years since the financial crisis, monetary policy has had an outsized, direct influence on the bond market, as central banks in the US, Europe and Japan, via their quantitative easing (QE) programmes, have bought government bonds in a bid to drive up their price, and so reduce yields.

In light of these considerations, it is not difficult to see why the yield on the 10-year US treasury bond has risen markedly this year, hitting a 7-year high of 3.25% in early October. The Trump tax cuts have resulted in strong economic growth in the US, and an acceleration in wage inflation has prompted markets to revise up expectations for the path of interest rates going forward.

Moreover, a widening in the budget deficit resulting from the tax cuts has seen increased US bond issuance at a time when the Federal Reserve is reversing its QE programme and gradually reducing its holdings of government paper.

Rising bond yields - good news or bad news?

There are clearly times when rising bond yields are welcomed by equity investors, and other times when they pose a threat. When low bond yields are a reflection of deflation risks, a subsequent rise in inflation expectations that lifts bond yields is likely to be welcomed by equity investors. Similarly, if real yields rise due to improved growth prospects for the economy, a stronger economic outlook could translate into higher profits forecasts, which would be supportive of the equity market.

However, rising bond yields are also potentially bad news. To the extent that rising government bond yields result in higher corporate bond yields, increased borrowing costs will eat in to profits. Higher borrowing costs will also threaten to slow the economy, thereby threatening corporate revenues and earnings. Indeed, the US housing market has shown clear signs of weakness in recent months, as mortgage rates, which move in line with long-term bond yields, have risen.

In addition, from an investor perspective, rising bond yields diminish the relative attractiveness of equities. For much of the period since the financial crisis, the paltry real yields on offer from US government bonds meant that investors had little alternative but to seek higher returns in riskier credit and equity markets. Fast forward to today, and the yields on both the 2-year and 10-year US government bond, 2.90% and 3.17% respectively, comfortably exceed both the 2.3% headline inflation rate and the 1.9% dividend yield on the S&P 500.

How high is too high?

Given that rising bond yields can potentially signal both good news and bad news for equity investors, the obvious question becomes at what level the latter starts to outweigh the former. We have seen estimates suggesting that once yields rise much above 3.5%, they could start to negatively impact on equity valuations. From an asset allocation perspective, one survey of global fund managers found that it would take a rise in the 10-year US yield to 3.7% to prompt a rotation from equities in to bonds.

With these findings in mind, it is perhaps not surprising that equity markets are becoming more volatile. Even though the prospect of renewed fiscal stimulus in the US has dimmed since the midterm elections, ongoing monetary tightening from the Fed still has the capacity to lift bond yields further.

Moreover, the recent run-up in US bond yields has not been accompanied by upward revisions to profits forecasts. On the contrary, consensus forecasts for S&P 500 2019 earnings per share have dipped back slightly in recent weeks, as analysts start to fret about the negative impact of a range of factors – including rising wages, US dollar strength, the US-China trade war and higher debt servicing costs – on profits going forward.

More attractive valuations

The good news is that following the pull-back in global equity markets during October, valuations have come down markedly and are looking more attractive. The forward price earnings ratio (p/e ratio) for the MSCI US equity index stands at 16.2 – down from nearly 19 at the start of the year. Moreover, the forward p/e on the MSCI UK equity index has fallen to 11.7, and the dividend yield of 4.5% is well in excess of UK inflation (2.4% in September) and the 1.49% yield on the 10-year gilt. In the UK, equities are still attractively priced relative to bonds.

Although tighter monetary policy in the US and subsequent rise in bond yields represent a headwind for risk assets globally, the traditional warning signals of a prolonged equity bear market – e.g. a blow-out in credit spreads or an inverted yield curve – are not flashing red.

As the global business cycle matures and event risks remain elevated, there is an argument for less aggressive positioning towards equities. However, with more attractive valuations emerging from the recent period of volatility and the probability of a near-term recession still low, a wholesale rotation from equities to bonds would appear premature. 

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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