Real yields in the driv­ing seat

Financial Mirror (Cyprus) - - FRONT PAGE - By Tan Kai Xian and Joyce Poon

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.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.