Are we closing in on a sharemarket crash?

By Dr Don Stammer - adviser to Altius Asset Management and columnist at The Australian. The views expressed are his own.

We’re being warned often that rising bond yields will cause an early and sharp crash in share prices.

Some commentators get straight to the point: “Bond yields up, shares down”. Others move into verbal overdrive: “Bond yields are surging … sowing extreme angst in US (and other) equities. Concern is mounting that the bond market’s travails are becoming an inescapable portent for stocks.”

In fact, the relationship between the bond yield and average share prices is neither simple nor, on the surface at least, apparently consistent. At times (such as 1994), higher interest rates on bonds have had a quick and negative effect on average share prices. At other times (for example in 2009), bond yields and share prices have moved up together.

Ashley Owen, my colleague at Stanford Brown, published a research report in 2016 analysing the 27 spikes in the US bond yield in the last 70 years or so. He found that about half of the surges in the bond yields was accompanied by rising share prices. It turns out that whether a rise in bond yields boosts or hurts share prices depends on key influences such as: the level of bond yields at the time; the main causes of the rise in bond yields; inflation and of expectations for inflation; and how short-term and longer-dated interest rates move relative to each other.

Looking ahead, these are my expectations:

  • Around the world, bond yields will likely move higher over the next several years because of inflation in the US, increases in the US cash rate and the major central banks winding back their programs of bond purchases.
  • For a while yet, sharemarkets may well deliver positive returns but in due course bond yields will likely reach levels associated with a serious and lasting downturn in average share prices.
  • Also, investors should expect occasional fake crises in which fears of a bond spike trigger share sell-offs that are soon reversed.

How do higher bond yields actually affect sharemarkets?

Some investment strategists like to compare the bond yield with the average earnings yield on shares. The earnings yield on shares is the total of after-tax profits of listed companies (whether paid out as dividends or retained within the companies) as a percentage of the market value of the listed shares.

The average earnings yield on shares (now 6.7 per cent) is the reciprocal of the average price-to-earnings ratio, which is currently 15 times.

When the earnings yield on shares significantly exceeds the bond yield, and a major fall-off in company earnings doesn’t seem a worry, it’s taken to be a good time to be holding shares.

The “Fed Model”, as this approach was called — because the then Fed chairman Alan Greenspan mentioned it often in the 1990s — seemed to work well in explaining that decade’s negative correlation between the bond yield and shares. But only for a time. As the Deutsche Bank global strategy group comments, “the Greenspan era may have simply reflected a particular artefact of history rather than any law of finance”.

Also, anyone who’s studied Finance 101 had it drummed into them that increases in the bond yield hurt share prices by raising the “discount rate” used in calculations of the “net present value” of expected future cash flows. The discount rate in such estimations is usually the long-term bond rate plus the “equity risk premium” (of about 5 per cent). If all else is equal, a jump in the discount rate reduces the present value of those future cash flows, and is negative for the sharemarket.

Often, though, other things aren’t equal.

Investors need to consider what’s causing the bond yield to spike. If it’s upgrades in economic growth, the sharemarket will likely strengthen. If a severe tightening in monetary policy is the cause of the higher bond yield, average share prices are more likely to fall.

Also, the lower the level of the “real” interest rate on bonds when the bond rate surges, the stronger the prospect that average share prices will move higher. (The real interest rate is the nominal yield minus inflation. In the US and Australia, the nominal yield on 10-year bonds has recently been 2.9 per cent; inflation has been a little below 2 per cent; the real bond yield is a bit less than 1 per cent.)

The Deutsche Bank global strategy team found that, in the US, a higher real bond rate usually “means higher equity multiples up to a point”.

They concluded: “In the US, the threshold data may indicate that high real rates imply higher equity multiples until a 4 per cent threshold (in the real yield on bonds) is reached.”

Deutsche Bank’s equity strategist in Australia, Tim Baker, has shown that a similar threshold effect applies in our markets. Up to a real yield on bonds of 4 per cent, the average price-earnings ratio for shares rises with the real bond yield (that is, “both respond to better growth”). But above that threshold, the relationship between the real rate on bonds and share prices is negative.

In brief, the risks of an early spike in the bond yield forcing the sharemarket into an early, deep and sustained slump may well be overplayed.

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