Dive into John Abernethy’s article in this week’s The View” as he writes on the Impact of Rising Bond Yields on Equity Markets
With ten-year US and Australian bonds marching towards 5% yields, I explore the effects of higher bond yields – that normally create headwinds for equity markets. In this post-Covid cycle, with interest rates lifting from extraordinary lows, the headwinds are obvious, but I suggest that they will be milder than historic precedents. Whilst history gives investors an insight as to how equity prices perform when bond yields rise, we must acknowledge how this time is different.
With rates lifting from ridiculously low levels, there can be little doubt that the interplay between rising bond yields and equity markets has been muted. However, it is likely that if long dated bond yields leap through 5%, equity markets will begin to feel pain. But then again, so will the $8 billion of buyers (this week) in the 31-year Australian Government bond tender. Those bonds cleared at a yield of just under 5% p.a.
The effect of higher bond yields on equity prices is fairly simple. If risk free returns measured by interest cash flows (receipts) rise, then the required cash flows from higher risk assets (such as equities) will be required to rise as well. If earnings growth is not pushing against the PER decline, then share prices decline to create the appropriate return for the investor.
The actual cash flows for individual companies can be calculated by deep financial analysis. Or they can be quickly estimated by calculating the “earnings yield” of a company. The earnings yield (the inverse of the PE ratio) is the percentage of the company’s earnings per share.
For instance, a company that is trading on a PER of 15x has an earnings yield of 6.66%. The earnings yield allows for a comparison of the company’s propensity to pay dividends (from cash flow) with the yields in fixed interest markets or with bond yields (the “risk-free” rate of return). From the earnings yield, both the dividend payment and yield can be estimated noting that a dividend yield should not normally exceed an earnings yield. From a PER of 15x and a payout ratio of (say) 60%, a dividend yield of 4% is attained. With franking, the pre-tax yield lifts above 6%.
In the chart below we see the lift in Australian bond yields (3-year bonds) towards 4% as ASX dividend yields pull back to 4% (pre-franking). We have not seen ASX 200 dividend yields being matched by bond yields for over a decade.
As yields (and cash flows) from bonds increase, asset allocators and investors consider reallocating funds from equities towards bonds or fixed income securities.
However, the allocation between equities (growth) and bonds (income) is complicated by actual or predicted inflation and the anticipated level of economic growth. This is because economic growth supports equities over bonds. Inflation devalues the cash flow or yield from fixed income bonds, particularly if those yields are below actual inflation (known as negative real yields). Indeed, that has been the feature of the last decade – a period where Central Banks utilized quantitative easing (QE) to manipulate interest rates to negligible levels.
Over the last 18 months, interest rates have risen and chased inflation higher. So far in 2023, in the face of rising interest rates, equity markets have performed reasonably well and contrary to dire predictions by some commentators. The world index has risen by about 10% this year (to 30 September) driven by the heavy weighting to the US market (which has risen by about 12%). However, we should remember that over the last 2 years, the US market index is flat (including dividends) with this year’s gains recovering prior year losses.
A disappointment has been the Australian market, seemingly dragged down by weakness in the Chinese economy and a devaluing AUD. In recent times, the Chinese Administration has lowered interest rates as economic growth forecasts for 2023 have been lowered from 5% to 4.5% by the OECD. While the Chinese equity market has pulled back given fears of financial issues across the property sector, the consumer has been resilient. Meanwhile, European markets have produced reasonable returns, and the Japanese market has been the star performer.
Also, we must remember that the strength in the Japanese equity market follows decades of poor returns. The Japanese equity market has lifted even as its ten-year bond yields have risen from 0.5% to 0.8% over the last 9 months. This is the clearest example that rising interest rates don’t always push equities lower particularly when those interest rates are well below inflation. The latest inflation reading in Japan is 3.5% and a full 2.5% above long dated bond yields.
Investors should always remember that investing is a long game that requires a constant eye to asset allocation – between growth and income assets. It also requires an acknowledgement of the volatility of returns that characterise the equity market.
The following chart (S&P500) shows equity markets invariably suffer drawdowns during each year. However, they are more likely to rise than fall. Over the last 40 years, equity markets have often risen in the face of rising interest rates and following an initial sharp drawdown (driven by fear that Central Banks will tighten too aggressively and cause a recession).
Moving back to a long-term focus on asset returns, the next table from Vanguard is instructive. It shows (over the last 30 years) that equities have produced a compounding annual return that is at least 3% higher than Australian bonds, but remarkably similar to international bonds. Why is this so, and what does it mean for future returns from asset classes?
First, the international bond returns (above) were bolstered by the extraordinary utilization of QE to drive bond yields to negligible levels. Remember negative bond yields in Europe and Japan. As bond yields decline, both the value and price of bonds rise. The major period of bond price appreciation was the second decade of this century (2010 to 2020) as yields across all bond maturities moved to or below zero.
In Australia, the utilization of QE was belated and started with Covid. Therefore, our bond returns could not match those of overseas returns. Notably, as bond yields everywhere have risen over the last 20 months, all bond markets have produced negative returns. Simply stated, whilst higher yields are generating higher cash flows for today’s buyers of bonds, the buyers of bonds over the previous 3 years (in particular) are suffering significant capital losses.
As for the future, in terms of predicting asset returns, it is always easier to predict the longer term (say 5 years) than it is to predict the next 12 months. That is because history for long term asset returns is fairly stable. Equity returns will outperform bond returns over the long term because economic growth and inflation aids growth assets more than it does for income assets.
However, the next year will see the cashflow benefits of higher interest rates flowing to fixed income investors at rates that have not been seen since before the GFC (14 years ago). As fixed income returns have become attractive, the relative attractiveness of equities is contested as explained in my opening paragraphs. Therefore, I think it is likely that fixed income returns will match and possibly exceed those of equities for the next 12 months at least. However, I do not subscribe to the belief that equities returns will be negative. Whilst I suspect that they will not be as good as those from fixed income, franking credits bolsters cash returns and dividends will grow with inflation and economic growth over time.
The acronym that was so popular a few years ago – TINA (There Is No Alternative – to Equities), has now clearly reversed. There are plenty of alternatives to equities – at least at the moment.
Does that mean that investors need to sell out of equities? Absolutely not. However, they should consider diverting any cash appropriately into fixed income yield. They should mildly de-weight equities and move into fixed income – especially if high quality yields can be accessed at above 6% and thus above inflation.
My final chart re-focuses attention towards the long term returns from the Australian equity asset class. Add in franked income that greatly benefits low taxed investors, plus a disciplined strategy of reinvesting dividends, and attractive returns will accumulate over time.
Disclaimer: Clime Asset Management Pty Limited | AFSL 221146 | ABN 72 098 420 770. The information provided in this post is intended for general use only. The information presented does not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Under no circumstances should investments be based solely on the information contained therein. Please consider the relevant disclosure document/s before investing in one of our products. Investment in securities and other financial products involves risk. An investment in a financial product may have the potential for capital growth and income but may also carry the risk that the total return on the investment may be less than the amount contributed directly by the investor. Investors risk losing some or all of their capital invested. Past performance of financial products is not a reliable indicator of future performance or returns.