(Repeats Friday story with no changes to text)
By Natsuko Waki
LONDON, July 19 (Reuters) – Investors have welcomed a recent
rise in bond yields in advanced economies as a sign of recovery
that should boost stocks, but if yields go much higher too
quickly, equities could start to look unattractive.
The scale, as well as the speed of the yield rise is key.
Too rapid an increase in yields would threaten a repeat of the
market crash seen in 1994, when stocks suffered a 10 percent
sell-off as bond yields rallied.
For much of the past 13 years, gradually rising bond yields
have been positive for stocks as they reflect better economic
prospects. But in late June that relationship broke down for the
first time in 2-1/2 years as volatility in bond markets soared
with rising U.S. Treasury yields.
Societe Generale reckons stocks in developed markets, where
much of the money printing that depressed yields took place, can
withstand a further rise in yields of around 140 basis points.
This is how its calculation works. Currently, equities are
largely under-bought because investors see them as risky and
demand a high reward to own them.
The picture is reflected in an unusually high equity risk
premium – the excess return that investors require to hold
stocks over risk-free bonds. In developed markets, the risk
premium currently stands at 5.3 percent, or 530 basis points,
well above the long-term average of 3.9 percent.
It would take a yield rise of more than 140 basis points to
push the risk premium below its long-term average – at which
point bonds would start to look more attractive than shares.
Applying a similar model, U.S. equities can absorb a rise of
around 120 bps in benchmark yields, while the Japanese market
has a larger wiggle room of 207 bps.
But in order not to spook investors, the shift in yields
must be gradual.
“Given the current earnings growth expectations, for the
equity risk premium to normalise, yield has to go up,” said
Roland Kaloyan, asset allocation strategist at Societe Generale.
“But it’s not just the normalisation in yields itself that
counts, but also the speed of the normalisation.”
In emerging markets, yields can rise another 170 bps before
the equity risk premium falls below the long-term average. China
has a comfortable 363 bps of room, while India, where a yield
rise of just 26 bps would be enough to tip the balance, appears
to be the most vulnerable.
Ewen Cameron Watt, chief investment strategist at BlackRock
Investment Institute, believes the market can run with a risk
premium of 3-4 percent before equities become too expensive.
“Real yields in equities at the moment are probably 2-2.5
percent with 5-10 percent dividend growth. You only take three
to four years to get to running 4 percent real yields through
that growth rate,” he said.
FEARS OF 1994
Normally, rising yields reflect a rosy economic picture.
Since 2000, U.S. equity returns were positive in 71 percent of
the months with rising U.S. bond yields, according to Deutsche
Asset & Wealth Management.
But the recent rise in volatility – a sign in markets of
insecurity and uncertainty about the future – may have soured
that relationship.
Bank of America Merrill Lynch’s Option Volatility Estimate
(MOVE) index, which measures implied one-month volatility in
U.S. Treasuries, more than doubled to hit a two-year high as
yields raced to 2.7360 percent earlier this month.
Prior to that, U.S. yields moved to 2.66 percent from 2.16
percent in four trading sessions in June.
“That leg caused wobbles in the equity markets and gave the
folks fears of another 1994-style scenario,” said John Bilton,
European investment strategist at Bank of America Merrill Lynch.
In early 1994, U.S. yields rose 150 bps in the matter of
four weeks or so, sending the S&P; 500 stock index down 10
percent in the process. The move came after a build-up of
inflationary pressures prompted a surprise Federal Reserve
interest rate hike.
While the volatility spike is similar, the economic
situation today is a little bit different. Inflation remains
benign and the Fed has repeatedly said its plan to scale back
its monetary stimulus depends on the economic recovery, and that
monetary policy will remain loose for the foreseeable future.
“Riskless rates can rise much more quickly than the equity
risk premium can contract,” said Bilton.
“Equity markets can absorb a gradual rise in yields. But
it’s the pace that can be destabilising.”
(Editing by Catherine Evans)
