Given Japan’s reverse yield gap, is it safe to assume its malaise of deflation and low economic growth has been exported to the western world.
The gap between bond and equity yields is becoming a critical issue in the world financial markets. According to this valuation model, popularly known as the “Fed model,” in equilibrium the real yield on the 10-year US Treasury Bonds should be similar to the S&P 500 earnings yield (that is, S&P forward earnings divided by the S&P level). Differences in these yields identify an over-priced or under-priced equity market. More specifically, if the S&P earnings yield is higher than the treasury yield, investors should sell treasuries and buy stocks (i.e. stocks are undervalued), while if the S&P earnings yield is lower investors should sell stocks and buy the more attractive treasuries (i.e. stocks are overvalued).
Until 1959, equity yields were in excess of bond yields both in the US and UK. The reason being investors had to be rewarded for the extra risk he/she took to invest in equities, known as the ‘equity risk premium’. After 1959, equity yields were below bond yields. This was because, as Professor Paul Marsh of the London Business School explains, the yield gap equals the expected risk premium on equities minus the expected growth in dividends which tend to rise with inflation. It may be recollected that in order to arrive at the equity yield, investors notionally add a risk premium to the bond yield. Therefore, inflation and growth are both crucial in determining whether the yield gap is positive or negative. The higher the inflation and growth, the more equity yields will be below the bond yields.
Of late, the dividend yield for the S&P 500, currently at 3.45 per cent, has risen above the yield for the 10-year Treasury note for the first time in a long period of 50 years. In the UK, the FTSE 100 dividend yield is at 6.24 per cent, much above the UK 10-year Gilt’s yield of 3.74 per cent. Are there any ominous portends of this once-in-fifty years phenomenon?
Resurgent bulls view this as evidence that stocks are undervalued and offering investors a “once in a generation” buying opportunity. The bears on the other hand believe that corporate dividends are going to fall sharply, as the message from lower bond yields is one of weakening economy, well into 2009 and beyond, as collapsing corporate profits begin to take centre-stage. To further their argument, they point out the dramatic collapse in commodity prices from their highs reached earlier in 2008. The inflation data coming out of the US and UK shows that even Consumer Price Indices have begun to decline. This disinflationary trend, according to many economists, is expected to gather momentum. In other words, the risk of inflation has been priced out of the US bond market. The current low 10-year Treasury yield thus reflects the removal of customary inflation premium. Fear of deflation has now hit the bond markets and policymakers. The fact that the US Fed plans to buy $500 billion of mortgages to salvage the beleaguered housing sector has added to the woes and caused the 3 per cent threshold for 10-year long-term US rates to be broken.
In an April 2008 draft of their paper entitled “Inflation and the Stock Market: Understanding the “Fed Model”, Geert Bekaert and Eric Engstrom carefully re-examine mechanisms that might explain why the Fed Model “works”. Using quarterly inputs for bond yield, S&P 500 index level and dividend yield, the economic forecast and a consumption-based measure of risk aversion spanning the fourth quarter of 1968 through 2007, they conclude that:
The chart, taken from the paper, plots the equity yield and the bond yield from the fourth quarter of 1968 through 2008. The equity yield is the aggregate dividend yield for the S&P 500, and the nominal bond yield is that of the 10-year constant-maturity Treasury note.
In summary, the high correlation between equity yield and bond yield derives rationally from the tendency for inflation to be elevated during recessions, such that both equity and bond premiums are relatively high during recessions.
Japan has a reverse yield gap. Can we therefore assume that the Japanese malaise of deflation and low economic growth will be exported to the western world? In a chart plotting the Japanese yield gap with nominal GDP growth over the ‘past decade’ also known as the ‘lost decade for Japan’, it was concluded that for nominal GDP to shrink, both inflation and growth must be negative. Peter Eadon-Clarke of Macquarie Securities points that when nominal GDP is negative, the ‘Yield Gap’ also tends to be negative. In Global Investment Returns Yearbook by Dimson, Marsh and Staunton, 2008; Professor Marsh has shows that both dividend growth and inflation were higher in the second half of the last century than in the first.
The current steep fall in Treasury Bond yields across the developed world does indeed suggest that investors fear deflation, while the steep rise in equity yields suggest that the investors fear a sustained collapse in dividends as also a higher risk premium for equities.
Reality, however, tends to indicate that low bond yields are because the investors have become risk-averse and need security. At the same time, enormous amount of new bond issuance is likely across the frontiers of the world as governments try to recapitalise banks and reflate their respective economies. At the same time, the cost of insuring UK government bonds against default have risen from 8 basis points in February 2008 to 110 basis points today. This shows that even bonds are not regarded as being absolutely safe for investors.
In the boom years, risk was ludicrously underpriced. Understandably so, we should now expect it to be become overpriced by a similar magnitude. After ‘reversion to the mean’, bond yields should recommence their upward ascent. Simultaneously, equity yields might also fall, to the extent to which investors regain their lost appetite for risk.
The author is a Wharton Business School MBA and CEO, Global Capital Advisors
