The key issue confronting equity investors is whether the bond market rout is a signal of more, or perhaps worse, to come. It’s a problem compounded by the fact that stocks -- showing stretched valuations more generally -- remain cheap relative to bonds (in the so-called Fed model).
Indeed, even after the recent market slump, bonds still send a strong signal that equities retain value. That hasn’t changed. Australian stocks are still running at a 50 per cent discount to bonds (on a bond yield/earnings yield basis), which is about double the average discount of the last decade. Not just cheap, but very cheap. Bond yields at home -- 3 per cent on the 10-year paper -- would have to rise another 3 per cent before they even got close to signalling fair value in the equity market.
Investors remain unsettled, however, although the backdrop suggests they needn’t be. How likely is it that the market will see another 3 per cent spike in yields? Or even 2 per cent? That’s not to say bonds aren’t expensive: in all likelihood they are well truly into bubble territory. Yet think about it, what exactly is going to burst that bubble in the near term, or perhaps even the medium term?
Of most importance, the US Federal Reserve continues to delay the tightening cycle -- members of the voting committee have been striking a more dovish tone in recent speeches, harmonising with the weaker economic data flow. That US Treasury yields still managed to push higher has more to do with events in Europe, the epicentre of the recent sell-off (spike in yields).
Yet what we’re seeing here doesn’t actually look too ominous. The 10-year German bund yield may have shot up 53 basis points, sure, but it still only sits at around 0.6 per cent and that’s down from 1.4 per cent at the same time last year. In any case, the lift looks to be more in response to a clear rebound in the economic dataflow and the dissipation of some deflationary concerns. How long that can last while yields at shorter maturities (of, say, one to four years) are still negative remains to be seen.
Aside from that, the European Central Bank remains committed to its quantitative easing program and the bank’s president, Mario Draghi, has made it clear that isn’t about to change. In effect we’re looking at about €60 billion ($85bn) of bond purchases each and every month up until September 2016, when the program is expected to end. That adds up to about €1.1 trillion. As it happens, that’s more than sufficient to buy all the planned government bond issuance in the euro area over the next year -- just under €1 trillion.
It’s the same story in Japan. The Japanese government plans to issue approximately ¥150 trillion ($1.6 trillion) of bonds over the next year or so -- all (or nearly all) of which will be absorbed by the Bank of Japan’s quantitative easing program (including rollovers of maturing debt). That’s not to forget that the Fed and Bank of England are still buying bonds as well -- rolling over existing maturities to maintain the size of their balance sheets.
The truth of it is that central banks are still the largest players in the bond market -- if it can still be called that -- and their buying will continue to see bonds well bid for the foreseeable future. That fact alone will keep a cap on yields.
That’s even before we get to the growing needs of pension funds and insurers to hold government debt to match liabilities, and the increased demand from banks to shore up their capital positions. If that wasn’t enough, investors shouldn’t forget the still sizeable proportion of investable funds held in cash. In the Australian context we’re still looking at rates up near 20 per cent of total funds under management. Cash returns in Australia might yield a comparatively lofty 2-3 per cent, but in Europe, Japan and the US it yields you nothing, and that’s when investors aren’t expected to pay for the privilege.
With that in mind, it’s hard to see how a sustained lift in bond yields could drive a sizeable outflow from equites. It’s also hard to see how lift in bond yields could be sustained. Anyway, in that unlikely event, it’s more probable that any outflow would come from cash, not equities. Households in Europe and the US alone hold well over $US20 trillion ($25 trillion) in cash deposits.
To that extent, the recent spike in bond yields probably sends a much more important signal to investors. That some of the concerns afflicting the world -- deflation, secular stagnation, etc -- have abated. Certainly for Europe, the return of even modest pricing, not to mention a lift in growth, is unquestionably positive for earnings in that region.
In that sense, the recent surge in bond yields might best be viewed as a positive signal for corporate earnings, rather than a negative signal for valuations
TCL Price at posting:
$10.20 Sentiment: Hold Disclosure: Held
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