Recently the Federal Reserve upgraded its forecast for US inflation and brought forward its timeline for raising interest rates.
Although bond yields have fallen recently, they are still considerably higher compared to one year ago. For example, the 10-year US Treasury yield has increased from a record low of 0.5% in 2020 to 1.4% today (21 June).
This trend is making some equity investors nervous, as all else being equal, higher yields erode the present value of future earnings and hence lower stock market valuations.
This relationship is illustrated below. The cyclically adjusted price-to-earnings ratio (CAPE), which divides stock prices by average profits over a 10-year period (in real/inflation-adjusted terms), tends to be inversely related to the level of real bond yields.
Currently, US bond yields are at historical lows while valuations are at extreme highs, so the risk is that equity markets suffer if yields rise and valuations contract.
However, rising yields do not always spell trouble for stock returns. The net effect can be positive if bond yields rise alongside an increase in risk appetite and valuations, as has been the case lately.
Alternatively, earnings may grow fast enough to offset the negative impact of higher discount rates.
But if earnings fail to grow fast enough, or if bond yields rise too quickly, markets may struggle to absorb the impact.
How have equities performed during previous rising rate cycles?
Since the 1970s, there have been approximately 11 rising yield cycles. Yet, contrary to popular belief, these periods were overwhelmingly positive for the stock market. For example, US equities delivered a positive total return in nine of these episodes, with an annualised average performance of 13.4%.
Around half of the time, equity markets were unable to absorb the impact of higher bond yields and so trailing price-to-earnings (P/E) valuations contracted. However, equities still fared well overall because earnings grew fast enough to offset the lower valuation multiple (% change in stock prices = % change in P/E x % change in earnings).
Where is the tipping point for equity returns?
Looking ahead, as the global vaccine roll-out accelerates and economic restrictions are loosened, it is reasonable to assume bond yields will increase further from their current levels.
So far, this has not derailed the equity market rally as investors have been willing to pay higher valuations in anticipation of a post-pandemic surge in corporate profits.
However, with valuations already at near record highs, this is unlikely to be sustainable. That puts the onus on earnings growth to support future returns. If that disappoints, equity returns could come under pressure.
We can assess the impact of a rise in yields by calculating how much the market’s P/E ratio would need to fall in response, such that relative valuations between equities and bonds (earnings yield minus bond yield) remain unchanged.
For example, at the moment, analysts are forecasting that US earnings-per-share (EPS) will grow by 28% over the next 12 months.
So what might happen to stock prices, assuming 1) they are right, 2) bond yields rise to 2% over the same period, and 3) relative valuations stay constant? Well, they would appreciate in value by 13% (% change in stock prices = implied % fall in P/E x % increase in EPS).
In fact, at that level of earnings growth, equities can tolerate yield levels of up to 2.5% before returns start to suffer.
On the other hand, if earnings fail to live up to expectations and yields only rise to 2%, EPS would still need to grow by at least 13% to offset the impact. These results are summarised below.
Markets will face a tug-of-war between growing profits and rising yields
Historically, equities have coped with rising yields because earnings growth is usually strong enough and/or valuations expand.
None of this is particularly surprising as rising rate cycles often coincide with improving growth prospects and inflation, which are supportive for stock prices.
The problem now is that US equities appear extremely expensive on an absolute basis, meaning valuations may be vulnerable to further yield increases.
Although the post-pandemic recovery in corporate earnings should help to insulate equity returns, current market optimism means there is a risk that earnings fall short of what analysts are forecasting.
An abrupt yield increase to 2% alongside a fraction of the projected earnings growth could also leave investors facing short-term losses.
Taken together, US equities can still generate positive performance for investors, as long as yield increases are gradual and roughly proportionate to earnings growth.
Read full reportWhat do rising bond yields mean for the US stock market?
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Authors
Sean Markowicz, CFA
Strategist, Strategic Research Group
