HIGHER US BOND YIELDS LED TO LOWER NIFTY P/E

SELL-OFF BRINGS BACK 2013 TAPER TANTRUM MEMORIES

Asharp sell-off in the equity market after a spike in bond yields in the United States should not come as surprise to equity investors. Historically, there is an inverse correlation between yields (or interest rate) on government bonds or Treasury yields and the price-to-earnings (P/E) multiple of the benchmark indices, such as Nifty50 or Sensex.

Bond yields in the US are up nearly 100 basis points from their lows in June last year, while the Nifty P/E remains close to a 25-year high of around 40x. The Nifty50 closed on Friday with a P/E multiple of 39.7x, down from 41.2x. The index was trading at a P/E of 28x at the end of December 2019 when bond yield in the US was 1.92 per cent.

“A panic in global bond markets led to a sharp rise in yields which spooked investors amid fears of an interest rate cycle reversal. Overnight, US Treasury yields leapt to their highest since the pandemic began, leading to a steep fall in global markets,” said Siddhartha Khemka, head retail Research, Motilal Oswal Financial Services.

In the last 15 years, the correlation coefficient between US Treasury yield and Nifty P/E multiple has been -0.4 on average. For example, in 2018 when the US bond yield rose from 2.8 per cent in August to 3.2 per cent by

October, the Nifty50 P/E ratio declined from 28.5x to 25x and the index corrected around 9 per cent. The rally in equities resumed from November 18 onwards as bond yields in the US cooled down.

Similarly, the post-covid outbreak rally on Dalal Street was preceded by a sharp decline in bond yields in the US and other developed markets, as central banks cut policy rates and pumped record level of liquidity into the system. The yield on 10-year US Treasury fell from 1.91 per cent at the end of December 2019 to 0.67 per cent by the end of March 2020, and finally to a record low of 0.53 per cent in June.

This lead to a re-rating (or upscaling) of stock valuation as earnings yields were now far higher than the yield on risk-free government bonds.

Earnings yield is the inverse of P/E multiple. An index or stock with a P/E multiple of 20x has an earnings yield of 5 per cent and a stock with a P/E ratio of 40x will have an earnings yield of 2.5 per cent. The earnings yield is quoted as a percentage and indicates the dividend yield for an investor at the current stock price, if the company distributes 100 per cent of its latest annual profits as equity dividend.

The Nifty50 earnings yield had hit a 5-year low of 5.2 per cent in March last year and stayed above 3 per cent during most of the last calendar year. In other words, the yield on large-cap stocks in India was up to 350 basis points higher than what foreign investors could earn on their bond portfolio in the US. The spread averaged around 200 basis points in the past 15 years.

This made Indian equity highly attractive to FPIS and they poured fresh capital on Dalal Street. FPIS bought fresh equities worth $30 billion during May and December 2020, followed by another $6 billion in the first two months of 2021.

This process is now reversing as bond yields in the US move higher, while the equity valuation in India remains stubbornly high. At the Nifty’s current P/E multiple, the earnings yield is around 2.5 per cent and the yield spread is now at a two-year low of around 100 basis points.

The spread is not enough to compensate investors for the higher risk involved in equity investment, compared to holding government bonds. In the past 15 years, the spread has been around 200 basis points (bps) on average. In the past, the markets corrected whenever the spread stayed below 200 bps for long and vice versa.

Central banks have expressed an intention to keep bond yields under control, something that can be a positive for the stock market, said market analyst Anand Tandon.

Given the many moving parts, including some signs of inflationary pressure, reigning in yields may be harder than one assumes, according to him. And this can put downward pressure on the market. “At some stage, it will start to hurt,” he said.

This may not be immediate. The current sell-off is partly because of people acting in anticipation of rising interest rates and not because there are definitive signs that the event is nigh, according to U R Bhat, director at Dalton Capital Advisors (India). He said economic indicators and central bank commentary did not point to the kind of immediate reversal that the current sell-off seems to anticipate.