Real yields in the driving seat

Notwithstanding Monday’s bounce, the stock market is a nervous place just now. After riding a post-Brexit rebound that saw both the S&P 500 and the Nasdaq Composite scale record highs on minimal volatility, investors are increasingly wondering about the extent of the potential near term downside, not just in the US but around the world. This nervousness is understandable. One of the key features of global equity markets in 2016 has been the lack of support from aggregate earnings. So far this year, 12-month trailing earnings per share on the MSCI US index have fallen -5.8%. Meanwhile, US dollar EPS on the MSCI ACWI ex-US have slumped -8.9%. Yet for the most part, equity markets have not collapsed. Indeed, with the exception of European markets, most are up in US dollar terms. The explanation for this buoyancy can be found in the behavior of real bond yields, and the implications are troubling.

The combination of weak earnings and relatively buoyant stock prices means that in most major markets the earnings yield — the inverse of the price to earnings ratio — has fallen by between zero and -2pp over the year to date. Changes in earnings yields can be broken down into two separate components: moves in the risk-free rate — that is in real sovereign bond yields — and changes in the equity risk premium. Decomposing the changes in earnings yield that we have seen this year into these two factors makes it clear that in most major equity markets it is the decline in real sovereign bond yields that has been in the driving seat.

Of course, real bond yields have declined because this year has seen nominal yields pushed down to levels unprecedented outside times of war or outright deflation. Part of the reason is the abundance of global savings at a time when the demand for capital to fund investment is relatively subdued.

However, the main factor depressing global bond yields are the trillions of US dollars pumped into the world’s financial system by the major central banks. This has several important implications for investors:

- As real bond yields have become the main engine of equity markets, the correlation between bonds and equities has turned positive. Government bonds are no longer an effective hedge for equities.

- As bond yields have fallen, the potential for bond market volatility has risen (because lower coupons on newly-issued long term bonds mean they have a higher duration and thus a greater sensitivity to any future interest rate increases).

- The combination of these two factors makes it more difficult for investors to reduce volatility in portfolio construction. Either they must accept lower returns for the same level of risk, or they must tolerate greater volatility in order to pursue former levels of return.

Should US long bond yields now normalize from close to overbought territory towards the neutral rate implied by Charles Gave’s bond valuation model the yield on 30-year treasuries will climb by 33bp from current levels. All else equal, that implies the US equity market will give up all its YTD gains and more. In short, a reversion in bond yields to neutral territory would be likely only to trigger a correction in equities, rather than a full-on bear market.

However, a bond market panic, in which long bond yields moved from close to the overbought bound of the model’s valuation range to the oversold bound would see long bond yields climb 100bp from the current level to 3.39%. In that event, the impact of the spike in real bond yields on earnings yields would translate into a downside move for equities of - 20%. Markets such as Brazil, where this year’s multiple expansion has been driven by the deep decline in real bond yields, would be the main victims should bond yields undergo such a violent re-pricing.