- The economic outlook is bleak.
- Bond yields are likely to fall.
- Falling bond yields are bullish for equities.
Wednesday, April 8, 2015
The recent economic telemetry suggests weakness:
> The Atlanta Fed forecasts 0.1% growth for 1Q15.
> The PPI is negative and core inflation is zero.
> The CRB index is down 30% since July.
> Five-year expected inflation is 1.6%.
> The real funds rate has risen from -4% to 0% (per St Louis Fed).
> Employment growth is slowing and participation continues to decline.
We are seeing the result of the premature withdrawal of fiscal and monetary stimulus in the face of a fragile recovery. Fiscal policy has been tightening for five years, and monetary policy has been tightening since 2012 (as measured by money growth). The credit aggregates have stopped shrinking but household credit has not resumed growth. The credit markets are still suffering from PTSD. Restrictive policy is the wrong medicine for this malady.
The data says to me that we are looking at negative shocks to inflation and the bond market which will push the 10-year yield back down to the 1.5% neighborhood. It has already fallen from 3% at the beginning of last year to 1.9% today. It has plenty of room to go lower: it fell as low as 1.4% in mid-2012.
Generally speaking, falling bond yields are bullish for equity valuations because (1) they lower the discount rate for future cashflows; (2) they drive investors out of bonds; and (3) they raise the equity risk premium. Since the Crash, the 10-year yield has fallen from 3.5% to 1.9%, or by 45%, while over the same period the Wilshire US Large-Cap Total Market Index has risen from 17,000 to 60,000.
The equity risk premium (ERP) measures the difference between the long-term risk-free rate and the expected return from equities over a similar horizon. Damodaran at NYU uses 8% as the expected return from equities and the 10-year yield as the risk-free rate. The historical return from equities has been volatile and the choice of time period will produce different results. For example, the total equity return since the Crash has been 21% per annum. It is important to remember that the return from equities is price appreciation plus dividends. This is why the total return indices outperform price indices.
Damodaran calculates today’s ERP at 5.5%, which is mid-range for the post-Crash period but quite high for prior periods going back to 1961.
Because the expected return from equities has been set at 8%, changes in the ERP reflect changes in Treasury yields: lower yields = a higher ERP. Therefore the risk to equity valuations is not fluctuations in earnings, dividends or even prices; the risk is higher bond yields. To decide whether stocks are currently cheap requires the investor to make a judgement about future bond yields. When I look at the data dashboard today, I see many things that suggest lower yields and only a few things that suggest higher yields (falling unemployment and rising employment costs). Therefore, I believe that stocks remain attractive and should go higher in the event that economic weakness results in lower bond yields.