The reflation trade-led pickup in developed market yields in recent weeks has created fear in the markets that a further uptick in yields could pose problems for the broader equities market, given elevated valuation multiples. And there appears to be further steam in US yields uptick, led by the resumption of normalisation as well as the forthcoming massive US fiscal support and US Treasury supply.
While lower yields did help equities post the Covid peak, equities may not necessarily de-rate if yields go up now. In fact, just ahead of the crisis, the 10-year US yield was close to 2 per cent, and the equity market was pretty happy against that backdrop. A study of upcycles of bond yields (50bp+) in the past 10 years showed that equities were up almost 100 per cent of those upcycles, except for the Covid period. The fortunes of emerging markets were somewhat mixed on those occasions, especially if that involved a stronger US dollar.
The move in yields since summer 2020 is technically not large, when the global economy is lifting. An assessment of the last two recession cycles shows an increase in US 10-year rates of at least 100 bp from their recession lows is typical just before or just after the recession ends.
Thus, by the standards of an expansion, neither the direction nor the magnitude of yield increases is odd. In fact, the anomaly of significant wedge between bond yields and inflation forwards/US ISM – both of which typically bear a close relationship with US Treasuries – implies there may be further fuel in the yield uptick.
However, there should not be too much ado about pace of uptick in yields as long as the reasons behind that are right.
- Current yield momentum is owing to cyclical economic acceleration and optimism led by the steepening of yield curve
- The tamed exit strategy of developed market central banks imply that they tread more cautiously on communication and action amid a nascent recovery, having learnt from their policy mistakes in the past.
- US Fed’s tolerance of higher inflation (average inflation targeting regime) will imply that 2%+ core inflation overshoots may be ignored if it is seen as transient. The Fed may be willing to tolerate ample liquidity and a potential for overheating. Further, a gradual exit process will also protect the Fed’s own balances sheet against potential losses. We expect develop market balance sheet to grow another 15% in CY21 after 50% in CY20
A look at the cycles of 1994 Fed hike cycle, 2013 Taper Tantrum and 2018 Fed hike cycle illustrates the importance of policy standpoints and underlying reasons for yields hike and equities behaviour. The 1994 Fed exit accident was owing to unprepared market of Fed’s aggressiveness and such disrupted template is unlikely to be repeated by the Fed.
In 2013, equities absorbed the tantrum cycle well, admittedly with some hiccups, as most macro indicators were still pointing to an expansionary cycle. Meanwhile, during the 2018 rate hike cycle, it was not the 3%+ bond yields that hurt equities, but increasing economic uncertainty amid US-China trade tensions, which dragged equities down and eventually were caught up by yields directionally.
So even as equities’ absolute valuations may look to not offer a fair risk premia currently, it is the relative valuation that matters more. On a relative basis, the US earnings yield spread is still some 100 bps+ above its long-run average relative to real bond yields. Thus, equities will be able to absorb a further uptick of up to 2% in US 10-year yield, amid reflation trade and early taper fears. Other supporting factors in favour are: 1) predominantly positive stock prices—bond yield correlation; 2) post-recession positive correlation between P/Es and EPS momentum in growth cycles; and 3) still-elevated HH financial savings which could re-route into equities.
(Madhavi Arora is Lead Economist at Emkay Global Financial Services. Views are her own)