Equity investors in for tougher time as markets face sharp downside risk

Yield spread between Sensex earnings and US 10-yr G-Sec narrowest in 12 years

Recent developments in the global equity and bond markets hint at a significant downside risk to the equity market. The US’ equity benchmark Dow Jones Industrial Average is close to giving up all its post-Covid gains and the financial incentive for foreign investors to own Indian equity assets is at the lowest since the 2008 global financial crisis.

The US equity benchmark closed on Friday at 29,592.85, just 41.43 points higher than its pre-Covid closing high of 29,551.42 made on February 12, 2020.

The Dow Jones is now down 19.6 per cent from its record high closing of 36,799.65, made on January 4 this year. Analysts attribute this to a sharp rise in yields or interest on risk-free US government bonds; it has greatly reduced the financial incentive for investors to put money in riskier assets, such as equity.

“Higher bond yields and higher inflation usually translate into lower asset prices and this is what we are seeing in various asset markets right now, including the equity and the US housing markets,” said Paul F Gruenwald, global chief economist and managing director, S&P Global Ratings. Yields on Treasury bills in the US have more than doubled this year, so far. 

The yield on 10-year US government bonds rose to 3.69 per cent on Friday, from 1.51 per cent at the end of December last year. The rise in short-term yields has been even sharper, with the two-year US Treasury now yielding 4.20 per cent against 0.73 per cent at the end of 2021.

In India, the spread between the Sensex earnings yield and the risk-free US 10-year government bond yield narrowed to a 12-year low (the lowest since January 2010) of 81 basis points on Friday because of a steady rise in bond yields in the US and a relatively high equity valuation in India. At Friday’s close, the Sensex had an earnings yield of 4.5 per cent; the yield on the 10-year US government bond was around 3.69 per cent.

In comparison, the spread was 208 basis points at the end of 2021 and 4.7 per cent in April 2020.

Earnings yield for a stock is the inverse of its price-to-earnings multiple and is the potential dividend yield for an investor if the target company or a basket of stocks distributes 100 per cent of the latest annual profit as equity dividend. Earnings yields are usually higher than risk-free bond yields to provide an incentive to investors to take the risk of investing in stocks, rather than government bonds.

Historically, a lower yield spread has translated into a sell-off by foreign portfolio investors (FPIs), leading to a market correction, while high yields have fuelled a rally on Dalal Street.

"The Indian equity markets are now one of the most expensive globally with the Sensex trading at a trailing price-to-earnings multiple of 22.3x and S&P 500 trading at a trailing P/E of 17x. This provides little risk-reward for FPIs to hold Indian equity assets against the risk-free US government bonds," says Dhananjay Sinha, director and head-research, strategy & economics, Systematix Institutional Equity.

Bond yields are expected to rise further in the US with the Federal Reserve indicating that it will raise its benchmark interest rate to 4.6 per cent from 3.25 per cent currently, and keep it there until at least 2024 to cool down inflation.

This would result in a contraction in the Sensex P/E multiples as stock valuation adjusts to higher interest rates.

"There was increased FPI selling in recent days due to rising dollar and bond yields in the US. With the dollar index above 111 and the US 10-year bond yield above 3.7 per cent, FPIs are unlikely to buy aggressively. The situation will change if the dollar index and US bond yields decline," said V K Vijayakumar, chief investment strategist at Geojit Financial Services.