Equity investors should keep an eye on bond yields
At present, there are no strong fundamental reasons to be worried about equity market valuation unless we see a big sell off in global bond prices. Those who are looking for reasons for a selloff in the stock markets may not find the answer in equity valuations. They may find their excuse in bond yields. Luckily for equity investors this reason is well looked after by major central banks, led by the Federal Reserve, the European Central Bank and the Bank of Japan. As long as any selloff in bond prices are gradual as we are experiencing it now and based on economic fundamentals then the risks to stocks are minimal.
The US Federal Reserve Bank is well aware of the impact of a big selloff in US Treasury bonds and it has been gradually preparing the market for a gradual rise of US interest rates. Also, it is working on unwinding its expanded balance-sheet. Also, the European Central Bank has been indirectly forcing banks to buy into their national debts by offering negative rates on bank deposits at the central bank. This has created continuous demand for European and US government bonds. How long this can last is all depends on economic growth and inflation outlook. Neither is threatening the central bank policies.
I understand that real long-term interest rates are much low and they might not be sustainable but we all know that there are strong fundamental reasons for the unusual situation. At some point in the future the very low unemployment rates that are seen in the developed economies might lead to higher wage pressure but to counter that there has been a dramatic change in the way businesses price their products nowadays. The technological revolution in the retail industry has been continuously capping prices. I believe the market has already priced in higher bond yields, in particular in the US.
While the consensus of Wall Street forecasters is still for low rates to persist, some economists have been warning about yields rising on US Treasury bonds. The yield on 10 years US Treasury bond is around 2.3 percent and could reach around 3 percent by next year. This kind of higher movement in yield is not a threat to the stock market unless it is accompanied by much higher inflation rate. Dividend yields on the S&P 500 is around 2.3 percent which is still attractive relative to bond yields even if it reaches 3 percent. I think as long as bonds are rallying faster than stocks, investors are encouraged to invest in less or attractive assets that has low inflation built into them.
If the US Federal Reserve’s model is anything to go by then the model is showing that US stocks are at one of the most compelling levels ever relative to bonds. Using 10-year inflation-adjusted bond yields, currently around 0.35 percent, the gap with the S&P 500’s earnings yield at around 3.95 percent, is 19 percent higher than the 20-year average. So, this could easily justify most indices hitting record highs. Yes, the Price Earnings Ratio is a bit stretched but investors should look forward for the next couple of year. This is supported by healthy corporate earnings in the US and now even in the eurozone. For interest rates to move much higher inflation is the key. Persistently low inflation is supporting low interest rates, bond yields and higher stock valuations.
I believe a sudden shock to the bond market will be short lived as US economic growth, low inflation, low interest rates and the weight of money will cap any big correction. That is if the Federal Reserve and the European Central bank do not change their policies in a manner that take the market by surprise. Again, the chance of this happening is very low. Equity investors are recommended to overweight stocks and enjoy the ride. They are not going to miss the sell signal. @Rasameel