We are starting 2022 as we started so many years ago, with investors worrying about the possibility of higher bond yields. Perhaps, what equity investors have to fear most is the reverse risk – that yields will actually fall.
To see this, let’s take a look at some of the mechanisms by which rising yields could hurt stocks.
The first is that the higher the bond yields, the more expensive stocks will look relative to them, and therefore the less likely investors will be to hold them.
Without a doubt, this was a reason in the past for stocks to suffer from rising yields. In the 1980s and 1990s, the spread between stock and bond yields was reasonably stable, so increases in bond yields triggered increases in stock returns and hence decreases in stock prices. But today the danger is greatly mitigated by the fact that UK stocks are remarkably cheap by historical standards. The dividend yield of the All-share index is now 5.6 percentage points higher than the yield of the 20-year indexed gilt. It’s close to a record. Even if bond yields were to rise by one percentage point, stocks would still be cheaper relative to bonds than they were anytime in the 20 years leading up to 2014.
The problem for stocks isn’t that rising bond yields make them look expensive. It’s that they might now be cheap for a very good reason: they offer little long-term growth.
A second threat is simply that a massive bond sale impoverishes investors; a one percentage point increase in ten-year gilt yields will cause their price to drop 8.5 percent. And the poorest buy fewer stocks.
This mechanism is compensated by another. Higher bond yields mean that last-pay pension plans will apply a higher discount rate to their future liabilities – the income they will have to pay out to future retirees. This would reduce the net present value of those liabilities, thereby strengthening their balance sheets and allowing them to buy more stocks.
Perhaps the greater danger associated with rising yields is the US market, as Atif Mian and his colleagues at Princeton University have pointed out. They show that low and falling bond yields have “disproportionately benefited” superstar companies, as the cost of borrowing falls more for them than for other companies, allowing them to grow faster than others.
Rising yields could reverse this process. And because these companies make up a large portion of the S&P 500, the entire US market would be dragged down; the five largest stocks (Apple, Amazon, Tesla, Alphabet and Microsoft) account for more than 23% of the S&P 500.
We got a hint of that on Wednesday when the Fed’s hint that it would raise interest rates – a move that should have been widely expected – triggered a sharp drop in the S&P.
You might think this is less of a problem for the UK market, which doesn’t have such superstar companies. True. But he is not immune. The fall in the prices of huge US stocks would reduce investors’ wealth and therefore their demand for stocks in general, including British ones. Most stocks around the world correlate with each other to some extent, so a fall in the US market would lower UK prices somewhat.
But a bigger problem than any of them is: why would bond yields rise?
The most likely reason is that inflation turns out to be higher than expected, causing investors to revise their short-term interest rate expectations upwards, with spillover effects on yields.
Such a scenario is not necessarily bad for stocks, however. A world in which demand is strong enough to cause sustained inflation and in which central bankers have enough confidence in the economy to raise interest rates is a world in which corporate profits are rising and an appetite for money is rising. risk increases, it’s good for stocks.
This, however, is only one possible scenario. If higher inflation is due to an increase in gas prices (and perhaps, although less likely, other commodities), this would lead to squeezing in income and profits – a squeeze that would be compounded by the rising short-term rates.
If that would hurt stocks, it wouldn’t be so bad for bonds. The same fears for economic growth that would push stock prices down would also keep bond yields lower. And that’s not to mention another possibility – that economic growth could be disappointing for other reasons such as weak growth in China or UK fiscal policy stifling demand.
And that is where the point lies. The biggest danger to stocks is not so much rising returns as falling, because a world in which returns are falling is a world in which investors are nervous.
Yes, rising yields would change the investment climate, perhaps triggering a shift from growth investing to value investing, and could sometimes disrupt stocks just because it’s so unfamiliar. But the alternative would be worse.