Wed. May 18th, 2022

The author is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’

The year did not start well for stock markets. Fears of inflation and tighter monetary policy are pushing up share prices as tensions between Russia and Ukraine obscure the outlook.

There is a feeling that government bond yields, after falling for 40 years, may be trending upwards again. There are three reasons why this could be bad news for stocks.

The first is that bonds and equities are competitive options for asset allocators. Higher returns make bonds more attractive and discourage some investors from switching stocks. The second reason is that higher bond yields make it harder for the economy to grow and more expensive for companies to obtain financing.

Third, equity valuations are linked to the expectation of future profit growth. To determine a present value of those future profits, they must be discounted at a rate that takes into account the time value of money – a dollar over 10 years is worth less than a dollar today. This rate is usually the return that can be predictably earned elsewhere, typically benchmark bond yields. Lower bond yields mean a lower discount rate and therefore justify a higher valuation level. In contrast, higher bond yields should mean lower stock valuations.

The valuation issue is perhaps the biggest threat to the stock market as the cyclically adjusted price / earnings ratio (which compares stock prices to the average of past 10 years’ gains) on Wall Street is almost 40, more than double the historical average. Furthermore, the valuation of technological stocks is mainly based on profits that have yet to be made, so they are more noticeably harmed by an increase in the discount rate.

But the market damage has been limited so far. Is there a trigger point where the level of short-term bond yields leads to a more catastrophic drop in stock prices? History gives us some clues. The yield on the 10-year treasury bonds peaked at about 15.8 percent in September 1981, before gradually declining to less than 0.6 percent in July 2020. But that decline was marked by a half-dozen periods when yields rose.

In 1987, for example, the 10-year yield jumped from 7.2 percent at the end of February to 9.6 percent at the end of September. This was followed by “Black Monday” in October 1987 when the Dow Jones Industrial Average fell by more than 22 percent in a single day.

In the late 1990s, yields rose from 4.4 percent at the end of September 1998 to 6.4 percent at the end of February 2000. Shortly thereafter, the dotcom bubble began to collapse. What about the great financial crisis of 2007-2008? The evidence is less clear. The 10-year bond yield rose from 3.4 percent in May 2003 to 5.1 percent in May 2006, but the first signs of stress in the financial system only appeared in April 2007 when the mortgage lender New Century broke.

Making an accurate claim on the level of bond yields that will now be needed to cause serious trouble is made more difficult by how low it has fallen. The 10-year yield has more than doubled since the low of 2020, but it only involved an increase of just over a percentage point. In the 1980s and 1990s, this apparently required increases of more than two percentage points in yield to cause significant problems. This suggests that a 10-year return of 2.5-3 percent would be the crucial level.

But the debate is complicated by the existence of a second trigger point built into the markets. As yields rise, it causes economic and financial damage. At some point, central banks may decide that the damage is sufficient to justify an end to monetary tightening. Indeed, even before central banks change course, investors can expect to be forced to do so. This could lead to them starting to buy both government bonds and shares in hopes of monetary easing.

In the last cycle, the Federal Reserve’s benchmark rate for funds peaked at 2.25-2.5 percent. At the end of July 2019, the Fed lowered rates with reference to “global developments” and “subdued inflationary pressures”. But inflation is now at 7 percent in the US and the Fed must surely continue to walk until it is brought under control.

Bulls will think that any upward shift in bond yields and interest rates will be temporary as inflation will eventually slow down. It will be possible to drive out any short-term turbulence. But the bears will believe that it will be impossible for the Fed to control inflation without causing serious damage to the economy and markets.

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