In recent months, inflation expectations have risen in both India and developed markets and its impact has been felt on bond yields globally, despite central bank QE (quantitative easing). Since then, a new narrative has settled among some bulls in the market. This new narrative is that the long-term correlation between bond yields and stocks is positive, and therefore is not a cause for alarm for equity investors. If expectations of better growth push inflation up and result in higher yields, that reflects optimism about the economy and stocks should perform well in such a scenario, they argue. Is there any data to support these claims? Is the increase in bond yield really good or bad for stocks?
When the movement of bond yields in any direction is used to justify the rise in stocks, then you need to be wary. Since the launch of monetary stimulus last year around the world by central banks and the crash in bond and deposit rates, the narrative that has been used to justify a bullish argument for equities (which has grown played since the March 2020 lows) was an alternative to stocks. Therefore, when bond yields actually start to rise as they have since the start of this year, an alternative to equities is emerging. So the bulls in the market have now shifted the narrative to why rising bond yields this time around are positive for stocks because, in their view, bond yields are rising in anticipation of better economic growth. Well actually, by that logic, bond yields fell last year in anticipation of a recession, so ideally that should have been negative for stocks, right? Logic is the victim when goal posts are changed.
Economic theory vs reality
Theoretically, the rise in bond yields is negative for equities. This is for four reasons.
First, increasing yields will increase borrowing costs and have a negative impact on corporate profits and the savings of individuals who are in debt.
Second, the increase in bond yields depends on inflation expectations and inflation erodes the value of savings. A lower value of savings implies a decrease in purchasing power, which will affect the demand of companies.
Third, the increase in bond yields makes them relatively more attractive as an investment option; and fourth, higher returns reduce the value of the net present value of the expected future profits of companies. NPV is used to discount estimates of future company earnings to determine the fundamental value of a stock. The discount rate rises when bond yields rise, reducing the NPV and fundamental value of the stock.
What does the reality and the data tell us? Well, it depends on when you limit or extend the scan (see table). For example, if you limit the analysis to when India experienced its best bull market and rising bond yields (2004-07), the correlation between the 10-year G-Sec yield and Nifty 50 (based on Bloomberg’s quarterly data) was 0.78. However, if you widen your horizon and compare for the 20 year period from early 2001 to now, the correlation is negative 0.15. The correlation for the past 10 years is also negative at 0.75.
In the table, we have taken 4-year periods since 2000 and analyzed the correlation, assuming investors have a 3-5 year horizon. The correlation is not strong for any period except 2004-07. It seems unlikely that we are currently witnessing the kind of economic boom of this period. It was one of the best periods in the global economy since World War II, driven by Chinese spending and the US housing boom compared to current growth driven by monetary and fiscal stimulus, whose sustainability is being challenged. in doubt in the absence of stimuli. That aside, Nifty 50 was then trading at the lower end of its historic valuation range from its highest levels to date. Inflationary pressures are also higher now. Against this backdrop, the case for a strong positive correlation between equities and bond yields is weak.
What it means for you
This implies that the data is inconclusive and that claims that bond yields and stocks are positively correlated cannot be used as the basis for investment decisions. At best, one can analyze sectors and stocks and invest in those that may have a clear path to better profitability when interest rates rise for specific reasons. For example, a company with a stronger balance sheet can gain market share over indebted competitors; market leaders with good pricing power can gain even when inflation is on the rise.
A final point to consider is whether a market rally that was built on the premise that there is no alternative to stocks in an ultra-low interest rate environment, can make a transition without crises towards a new paradigm of higher interest rates even if this is motivated by optimism around growth. An increase in the Fed’s expectations for the first interest rate hike in two full years prompted temporary sales of emerging market stocks, bonds and currencies, until the governor’s comments from the Fed calmed the markets. This may be an indication of the fragility of the markets vis-à-vis US interest rates and yields.