Yield gap between Sensex earnings, 10-year US bond narrowest since 2000

A combination of high equity valuations in India and a steady ascent in bond yields in the United States has pushed the spread between the BSE Sensex earnings yield and the US 10-year bond yield to its narrowest since 2000. Moreover, the spread has languished in negative territory for three consecutive months.

Historically, a protracted period of negative yield spread has followed major corrections in the equity market, such as the dotcom crash of 2000. Similarly, the yield spread was submerged in negative territory in the months preceding the January 2008 market correction. In contrast, the spread luxuriated in positive territory for 188 unbroken months between January 2008 and August 2023. 
 

The yield spread narrowed to -0.61 per cent on Monday, a stark contrast to 0.99 per cent a year ago and the 20-year average spread of 2 per cent. The benchmark index’s trailing price-to-earnings (P/E) multiple was 24.7x on Monday, translating into an earnings yield of 4 per cent. For comparison, India’s benchmark equity index was trading at a trailing P/E multiple of 22.7x at the close of April 2023, with an earnings yield of 4.4x. The yield on US 10-year government bonds surged 120 basis points from 3.42 per cent at the end of April 2023 to 4.66 per cent on Monday.

 

“We harbour optimism for the Indian equity markets on a medium-to-long-term basis. However, valuations make us cautious about the near-term return potential,” wrote Vinay Paharia, CIO of PGIM India Mutual Fund.
 

A negative spread between the Indian equity yield and the US long-term Treasury bond yield renders investment in Indian equities unappealing for foreign investors, generally precipitating a selloff by foreign portfolio investors (FPIs) and volatility on Dalal Street.
 

Foreign portfolio investors offloaded nearly Rs 21,400 crore worth of Indian equity in the past six trading sessions and have cumulatively withdrawn Rs 25,400 crore from the Indian equity market in April thus far. In contrast, FPIs were net buyers in February and March this year.
 

The Sensex declined by 2.6 per cent in the previous five trading sessions until it rose 0.77 per cent on Monday. It is nearly flat in April, so far. The index cumulatively gained 2.65 per cent in February and March this year, in line with net buying by FPIs.

“India flows have also decelerated over the past few weeks but remain among one of the strongest regions for foreign investors, alongside Japan. Last week’s inflows into India dedicated funds of $114 million is the slowest since May 2023,” wrote Sunil Jain of Elara Capital in a recent report.
 

The recent decline in earnings yield echoes the one that transpired in 2007. The yield spread was negative for three months between October and December in 2007 and had plummeted to a then seven-year low of -0.45 per cent in October 2007. Stock prices then peaked in the first week of January, followed by a steady decline. The contraction in yield spread was due to a sharp escalation in equity valuations and a rise in the benchmark bond yield in the US by 45 basis points between February and June 2007. The Sensex trailing price-to-earnings multiple spiked from 19.8x at the end of March 2007 to a high of 27x at the end of December 2007. Consequently, the index earnings yield declined to 3.7 per cent at the end of the period from 5 per cent in February 2007. The BSE Sensex corrected by nearly 34 per cent between December 2007 and June 2008.
 

Similarly, the yield spread was in negative territory for 20 consecutive months between July 1999 and February 2001 and had declined to a record low of -2.66 per cent in May 2000. This was due to a combination of a rise in bond yields and higher equity valuation. The yield on US 10-year Treasury bonds was up 200 basis points during the 12 months ended January 2000. Meanwhile, the Sensex trailing P/E multiple more than doubled between April 1999 and June 2000, from 13.8x to 29.4x.
 

The BSE Sensex peaked in February 2000 at 6,150.9 and corrected by 30 per cent over the subsequent six months.