The relationship between bond and equity yields and how inflation impacts both
ECONOMIST. com has a column called Market.View that appears only on its online edition. This week the column touched on the relationship between bond and equity yields and how inflation affects both of them.
First off, why is it that when analysts talk about equity market valuation, they also bring up bond yields? What are the implications of rising bond yields for equity markets?
One approach, according to the article, sees equities and bonds as assets that compete for a place in investors' portfolios. If one asset class becomes overpriced, investors will flock to the other.
The conventional way of comparing the two is to look at the yields. But which equity yield should investors look at? In more conservative times, they looked at the dividend yield. Until the late 1950s it was common for the dividend yield on the stock market to be higher than the government-bond yield, says the article. After all, since dividends could be cut, they were more risky.
But pension funds and other institutional investors noted that, in a broadly diversified portfolio, dividends would tend to rise pretty steadily over time. That growth meant that equities could trade at a lower dividend yield than bonds. The wisdom of this shift into equities seemed to be confirmed when the real value of bonds was devastated by the inflation of the 1960s and 1970s, The Economist noted.
Fed Model
By the 1990s, investors had turned to the earnings yield, the inverse of the price-earnings (PE) ratio. So if the PE ratio is 20, the earnings yield would be 5 per cent.
A paper by US Federal Reserve economists led to widespread belief in the Fed Model - that the market was fairly priced when its prospective earnings yield was equivalent to the 10-year Treasury-bond yield.
So according to this model, falling bond yields are good news for equities. The model seemed to be correct - at least for a while. That was the long period of disinflation from 1982 onwards. During that time, nominal bond yields fell sharply and share prices rose substantially.
However, this model did not work prior to 1960. The earnings yield then was much higher than the government bond yield because companies only paid out a fraction of their earnings as dividends. And the model did not work in the Japan of the 1990s, where sharply falling government bond yields did not help the stock market.
Disillusionment with the model came in 2000-02, according to The Economist. Bond yields fell sharply, but this was not good news for shares. Indeed, investors were switching out of shares and into fixed income in the wake of the dotcom bubble. Equities looked cheap on the basis of the Fed model and got cheaper.
A lot of people began to argue that the model was rubbish. After all, if lower bond yields were the result of lower inflation, why should equities benefit? Profit forecasts would have to fall as well.
The Economist thinks that perhaps the answer to the riddle can be found in some of the figures highlighted by Richard Cookson, a strategist at HSBC, who was formerly a writer with the magazine. His theory is that bonds may move in sync with equities at some parts of the economic cycle but not at others.
When recession or deflation looms, government bonds are relatively unaffected but equities suffer because profits are likely to fall.
Since 1900, when inflation has been in the one to 4 per cent range, price-earnings ratios on the stock market have averaged between 17 and 19 - in other words, an earnings yield of 5 to 6 per cent.
But when inflation has been below one per cent, PE ratios have averaged just 14 (an earnings yield of 7 per cent). In such circumstances, bond yields fall but earnings yields rise.
Charts show the relationship between inflation and stock market PE, market valuation was highest - just under 20 times - when inflation was between one and 2 per cent. The next highest valuation was when inflation was between 2 and 3 per cent.
The market PE was below 15 times when there was deflation - that is, when inflation was negative. And it fell below 10 times when inflation exceeded 10 per cent a year.
The Economist article said that in the current situation, bond yields are rising because of inflation - the headline rate is above 4 per cent in Britain and America. And that is a problem for equities, since 4 per cent seems to be a key figure. Average PEs when inflation has been in the 4-5 per cent range have been 15. And by the time inflation reaches 6-7 per cent, the PE drops to 11.
'The problem for stockmarket investors is that the economy currently seems posed between extremes,' according to the article. 'If inflation returns, that will be bad for valuations. If recession wins out, that will be bad for profits. It is an unpalatable choice.'
The table presented with the article piqued my curiosity. Does the Singapore market behave the same way?
To find out, I downloaded the Thomson Datastream's calculations of the weekly PE of Straits Times Index (STI) going as far back as 1973. The average PE for the year was taken, and then I matched the PE to the inflation rate for that year, which I found on the Singapore Statistics website.
Inflation factor
What I found was that the Singapore stock market appears to be more averse to inflation than to recession.
In the four years when inflation was negative - 1976, 1986, 1998 and 2002 - the average PE for the STI ranged from 14.5 times (2002) to 23.4 times (1986). The average PE for those four years was 17.1 times.
The inflation rate most comfortable for the market is between one and 2 per cent. During those years, the average market PE was 19.4 times.
Market multiples gradually declined as inflation rose. In 1974, when inflation rate exceeded 20 per cent a year, the STI was trading at 10.9 times earnings. The market PE plunged from a high of 26.6 times in 1973 - when inflation touched 19.6 per cent - to less than half that figure the following year.
But there was only one observation each for inflation rates of between 19 and 20 per cent - that is, in 1973, and for an inflation rate above 20 per cent, in 1974.
There were two observations when inflation hit the 8 per cent range. The years were 1980 and 1981. The PEs in those years were 12.9 and 12.4 times.
With inflation expected to hit 6 per cent this year, perhaps it is no wonder the STI is now trading at just 11 times PE. The current PE is one standard deviation below the mean PE of the STI since 1973.
On the other hand, the STI has been trading at such low-teen PEs for the past two or three years, when inflation was between 0.5 and 2 per cent.
So inflation may not be the only cause of the low valuation for the Singapore market.
Since we are at it, I also plotted the graph of how the STI, the Urban Redevelopment Authority property index, Singapore's gross domestic product and the consumer price index have grown since 1975. As you can see, property prices ran significantly ahead of the GDP from 1993 until 1997. They corrected sharply in the subsequent seven or eight years.
In the past two years, both property and the stock market indices have again spurted at a sharper trajectory than GDP. The current easing of property prices is perhaps to be expected, the argument of Singapore being a global city notwithstanding.
Published June 21, 2008
Show Me The Money
By TEH HOOI LING
SENIOR CORRESPONDENT
The Business Times
ECONOMIST. com has a column called Market.View that appears only on its online edition. This week the column touched on the relationship between bond and equity yields and how inflation affects both of them.
First off, why is it that when analysts talk about equity market valuation, they also bring up bond yields? What are the implications of rising bond yields for equity markets?One approach, according to the article, sees equities and bonds as assets that compete for a place in investors' portfolios. If one asset class becomes overpriced, investors will flock to the other.
The conventional way of comparing the two is to look at the yields. But which equity yield should investors look at? In more conservative times, they looked at the dividend yield. Until the late 1950s it was common for the dividend yield on the stock market to be higher than the government-bond yield, says the article. After all, since dividends could be cut, they were more risky.
But pension funds and other institutional investors noted that, in a broadly diversified portfolio, dividends would tend to rise pretty steadily over time. That growth meant that equities could trade at a lower dividend yield than bonds. The wisdom of this shift into equities seemed to be confirmed when the real value of bonds was devastated by the inflation of the 1960s and 1970s, The Economist noted.
Fed Model
By the 1990s, investors had turned to the earnings yield, the inverse of the price-earnings (PE) ratio. So if the PE ratio is 20, the earnings yield would be 5 per cent.
A paper by US Federal Reserve economists led to widespread belief in the Fed Model - that the market was fairly priced when its prospective earnings yield was equivalent to the 10-year Treasury-bond yield.
So according to this model, falling bond yields are good news for equities. The model seemed to be correct - at least for a while. That was the long period of disinflation from 1982 onwards. During that time, nominal bond yields fell sharply and share prices rose substantially.
However, this model did not work prior to 1960. The earnings yield then was much higher than the government bond yield because companies only paid out a fraction of their earnings as dividends. And the model did not work in the Japan of the 1990s, where sharply falling government bond yields did not help the stock market.
Disillusionment with the model came in 2000-02, according to The Economist. Bond yields fell sharply, but this was not good news for shares. Indeed, investors were switching out of shares and into fixed income in the wake of the dotcom bubble. Equities looked cheap on the basis of the Fed model and got cheaper.
A lot of people began to argue that the model was rubbish. After all, if lower bond yields were the result of lower inflation, why should equities benefit? Profit forecasts would have to fall as well.
The Economist thinks that perhaps the answer to the riddle can be found in some of the figures highlighted by Richard Cookson, a strategist at HSBC, who was formerly a writer with the magazine. His theory is that bonds may move in sync with equities at some parts of the economic cycle but not at others.
When recession or deflation looms, government bonds are relatively unaffected but equities suffer because profits are likely to fall.
Since 1900, when inflation has been in the one to 4 per cent range, price-earnings ratios on the stock market have averaged between 17 and 19 - in other words, an earnings yield of 5 to 6 per cent.
But when inflation has been below one per cent, PE ratios have averaged just 14 (an earnings yield of 7 per cent). In such circumstances, bond yields fall but earnings yields rise.
Charts show the relationship between inflation and stock market PE, market valuation was highest - just under 20 times - when inflation was between one and 2 per cent. The next highest valuation was when inflation was between 2 and 3 per cent.
The market PE was below 15 times when there was deflation - that is, when inflation was negative. And it fell below 10 times when inflation exceeded 10 per cent a year.
The Economist article said that in the current situation, bond yields are rising because of inflation - the headline rate is above 4 per cent in Britain and America. And that is a problem for equities, since 4 per cent seems to be a key figure. Average PEs when inflation has been in the 4-5 per cent range have been 15. And by the time inflation reaches 6-7 per cent, the PE drops to 11.
'The problem for stockmarket investors is that the economy currently seems posed between extremes,' according to the article. 'If inflation returns, that will be bad for valuations. If recession wins out, that will be bad for profits. It is an unpalatable choice.'
The table presented with the article piqued my curiosity. Does the Singapore market behave the same way?
To find out, I downloaded the Thomson Datastream's calculations of the weekly PE of Straits Times Index (STI) going as far back as 1973. The average PE for the year was taken, and then I matched the PE to the inflation rate for that year, which I found on the Singapore Statistics website.
Inflation factor
What I found was that the Singapore stock market appears to be more averse to inflation than to recession.
In the four years when inflation was negative - 1976, 1986, 1998 and 2002 - the average PE for the STI ranged from 14.5 times (2002) to 23.4 times (1986). The average PE for those four years was 17.1 times.
The inflation rate most comfortable for the market is between one and 2 per cent. During those years, the average market PE was 19.4 times.
Market multiples gradually declined as inflation rose. In 1974, when inflation rate exceeded 20 per cent a year, the STI was trading at 10.9 times earnings. The market PE plunged from a high of 26.6 times in 1973 - when inflation touched 19.6 per cent - to less than half that figure the following year.
But there was only one observation each for inflation rates of between 19 and 20 per cent - that is, in 1973, and for an inflation rate above 20 per cent, in 1974.
There were two observations when inflation hit the 8 per cent range. The years were 1980 and 1981. The PEs in those years were 12.9 and 12.4 times.
With inflation expected to hit 6 per cent this year, perhaps it is no wonder the STI is now trading at just 11 times PE. The current PE is one standard deviation below the mean PE of the STI since 1973.
On the other hand, the STI has been trading at such low-teen PEs for the past two or three years, when inflation was between 0.5 and 2 per cent.
So inflation may not be the only cause of the low valuation for the Singapore market.
Since we are at it, I also plotted the graph of how the STI, the Urban Redevelopment Authority property index, Singapore's gross domestic product and the consumer price index have grown since 1975. As you can see, property prices ran significantly ahead of the GDP from 1993 until 1997. They corrected sharply in the subsequent seven or eight years.
In the past two years, both property and the stock market indices have again spurted at a sharper trajectory than GDP. The current easing of property prices is perhaps to be expected, the argument of Singapore being a global city notwithstanding.
Published June 21, 2008
Show Me The Money
By TEH HOOI LING
SENIOR CORRESPONDENT
The Business Times
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