Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards

Portfolio > Alternative Investments > Private Equity

Equity-Market Smiles Don’t Have to Become Frowns

Your article was successfully shared with the contacts you provided.

As 10-year Treasury yields climb, investors are fixated on 3%, a level where many fear an equity market meltdown. Yet that threshold has no fundamental relevance. Instead, investors should try to understand why yields are rising, and draw the right investment conclusions.

A common misconception is that equity prices are inversely related to bond yields. Surely, that is wrong. The Nikkei lost almost three-quarters of its value in the 1990s, a period that coincided with a plunge in Japanese government bond yields. More recently, global equities advanced strongly in the second half of 2017, along with bond yields.

No simple rule links equity and bond performance. The best framework for understanding the dynamic is the dividend discount model, which relates the equity market multiple to trend growth, the equity risk premium and the bond yield (or the “risk-free” rate). And, all else equal, this model says that the equity multiple rises if bond yields or the equity risk premium fall, or if long-term growth improves.

But all else equal is rarely correct. Changes in bond yields interact with the other drivers of share prices — the equity risk premium, the dividend yield and expectations about trend growth. So it’s complicated.

To understand the implications for equity market multiples, the first step is to determine what is driving yields up. Three possible changes could be at work: improved trend growth, higher inflation or sovereign risk.

For example, an anticipated acceleration of trend growth is surely positive for equities. It represents a durable increase in future cash flow. On the other hand, jitters about sovereign creditworthiness would undoubtedly increase uncertainty and depress equity valuations.

But the most interesting case is an increase in inflation expectations. That is particularly relevant now, insofar as rising inflation expectations are responsible for most of the acceleration in U.S. bond yields over the past six months.

If inflation rises, so do future (nominal) cash flows, producing offsetting impacts on equity valuations. That suggests that the principal influence is the equity risk premium. How does it respond to rising inflation?

There is ample evidence to suggest that the equity risk premium may have a non-linear relationship to expected inflation. Think of it as a “smile” or an upturned mouth because the equity risk premium rises at inflation extremes, turning up in deflation but also as inflation soars.

The reason is that inflation extremes increase economic uncertainty, and hence the riskiness of owning stocks. Low or negative inflation typically exists during severe recessions. Deflation also increases default risk. On the other hand, high and accelerating inflation prompts central banks to tighten, which increases the risk of recession. It is only in the neighborhood of price stability that the equity risk premium bottoms, coinciding with peak valuations.

The smile also determines stock/bond correlation. At price stability, this relationship is indeterminate: it can be positive or negative as other factors dominate. But move too far to the left (toward deflation) and the price correlation turns sharply negative: bonds rally, stocks slump. Move too far to the right (too much inflation) and the stock bond price correlation becomes strongly positive: stock and bond prices fall in tandem.

Fast-forward to today. Markets are skeptical that President Donald Trump’s brand of economics will lift trend growth much as real yields are not yet reflecting that movement. But inflation expectations are edging up, stoked by fiscal expansion. Despite the fact that realized inflation is today in the “sweet spot” of price stability, the market is beginning to fret about an overshoot, as well as the risk that more aggressive tightening from the U.S. Federal Reserve could then derail the expansion.

Will the equity risk-premium smile become a frown?

It doesn’t have to end badly. But inflation is the crux. So watch inflation and the Fed’s response. A balanced portfolio of stocks and bonds is the worst of all choices if inflation begins to accelerate. Instead, consider swapping bonds for non-directional strategies. This is when alternatives must deliver on their promise of uncorrelated returns.


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.