CUT & THRUST: It is called Bond, stupid!
As we go to print, the Dow Jones is down 428 points, once again on fears of rising bond yields. Financial Chronicle traces the fear gauge of bond street across the world and their impact on equities

Bond Street is a major shopping hub in the West End of London. It links Piccadilly in the south to Oxford Street in the north, the former one of London's busiest squares, while the latter is one of the world's famed shopping districts. Anyway, this treatise is far removed from the fashion of Bond Street or the masses of people who throng Piccadilly Circus, though bonds are very much the flavour of the season, creating bedlam across world stock markets. Leaving behind in its wake a trail of ferment, fear and tumult. The last week or so has reminded me of a Jean Paul Belmondo movie called ‘Fear over the City’, here tanking markets shook and trembled. The temblor became a seismic shake of epic proportions when the Dow Jones collapsed by 100 plus points, an event unprecedented in history. Of course, the basic threat to equities emanates from a spike in interest rates and this is why there is a kerfuffle in the US. What we are witnessing is the great joust for primacy between bonds and equities. Treasury yields are moving higher. The latest dance of the bonds came on concerns about more deficit spending in the US, after the Senate struck a budget deal that raises the spending cap by $300 billion, more than the market expected. A soft 10-year auction added to the pick up in yields, which move opposite prices. It is a sensitive time for global markets, the cues are all coming from the US. Traders are also keeping an eye on Treasury's auction of $16 billion in 30-year bonds, obviously concerned it too could send yields higher.

Bond Street dominates the discourse back home as well. The situation is precarious for different reasons. The difference between the risk free and the earnings yield (NTM E/P - Next Twelve Months Earnings/Price ratio) has, in the past, been a good indicator of risk-reward between the bond and equity markets. The yield gap has been higher than 250bps over the past few weeks, the highest since August 2007. The main factor driving this, the rising valuations of the equity market, is a function of the earnings growth expectations and sentiment that can be partly explained by flows. For now, JM Financial, for instance, is going with the view that the growth estimates are unlikely to see a meaningful revision upwards, as seen from the latest 3Qtr results wherein for the companies that have reported till date, the earnings growth is running behind estimates (see tables and charts) even after many quarters of disappointments. Their various sectoral analysts also indicate balanced risks on growth. This leaves yields and domestic flows as factors that could sustain or break down the valuations. The RBI’s latest monetary policy seems to suggest that risks on inflation are on the upside indicating no respite from yields. At least one indicator indicates that the market valuations indeed look stretched and that it would be difficult to make absolute returns in the market this year. Liquidity will remain the cornerstone of added impetus for equity markets. Remember that FPIs could be chasing the Golden Fleece of debt if the yields remain where they are. The RBI's non interventionist policy on Thursday may have given equity markets a reprieve, but if banks start raising interest rates individually, given the central bank's hawkish stance, then who knows where we are headed.

 

New menace

The drum beats are not positive, the ferocity of the fall has shaken one and all. Bloomberg explained it well when it said - Equity investors have faced threats before: swollen valuations, a stagnating economy, stretches of declining earnings. Now investors are dealing with a new menace, and it’s wreaking more havoc than anything in two years. It is called Bond and it is not James Bond, nor does it have anything to do with Bond Street. It’s the bond market, where the biggest jump for interest rates since March has bulls questioning the staying power of an equity advance now seven months from being the longest ever. So drastic is the run up in yields that it’s knocking stocks down during a period when analysts are pushing up earnings estimates four times faster than any time since 2012. Fears over overbought equities have been in place for sometime now, January's rapid buying frenzy notwithstanding. The underlying strength of the US economy remains in place and even earnings have been rock solid there. Earnings miss and rush for yields is perhaps the single biggest risk for fragile India, debilitated with long term capital gains tax and dividend distribution tax of equity mutual funds.

The bond yield hike is a worldwide phenomenon. Last week, rising bond yields prompted the Bank of Japan (BoJ) to intervene in the bond market for the first time since July last year. India too cannot remain unaffected, so it is witnessing a rise in yields on 10-year bonds. RBI cancelled a scheduled bond auction on Friday, triggering a relief rally in the bonds, which had climbed a 23-month high a day earlier amid concerns over higher-than-expected fiscal deficit projection for the next financial year. India's 10-year bond yield hit 7.56 per cent per annum on Friday, up 115 basis points from 6.41 per cent it quoted at the end of July 2017. Simple theorem is that when bond yields rise, the opportunity cost of investing in other assets, including equities, rises. Ergo - you move to other asset classes. This makes investment in shares less attractive. The RoRo syndrome kicks in -  Risk-on, risk-off (RoRo) investing describes a process where investors move to riskier potentially higher yielding investments and then back again to supposedly lower yielding investments which are perceived to have lower risk. To break it down further – Risk-on risk-off is an investment setting in which price behaviour responds to and is driven by changes in investor risk tolerance. Risk-on risk-off refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments; when risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.

 

Perceived risk

Not all asset classes carry the same risk. Investors tend to change asset classes depending on the perceived risk in the markets. For instance, stocks are generally seen as riskier assets than bonds. Therefore, during periods of stocks outperforming bonds, this is said to be a risk-on environment. When stocks are selling off, falling off the cliff; investors run for shelter in bonds or gold, the environment is said to be risk-off. For the first time since the 2008 meltdown, the US economy has seen resilience and growth. The United States is projected to grow 2.7 per cent in 2018 as President Trump’s tax cuts boost growth, the International Monetary Fund said in a new report recently. But, deep inequality remains in the country and the IMF does not expect the growth to last long. “We certainly should feel encouraged by the strengthened growth, but we should not feel satisfied. There are still too many people who are left out of that recovery and acceleration,” said Christine Lagarde, head of the IMF. The IMF had originally forecast just 2.3 per cent growth for America but lifted its projection significantly after Republicans, in late December, passed the largest overhaul of the US tax code in over 30 years. The massive reduction in the corporate tax rate from 35 per cent to 21 per cent should stimulate business investment and growth, the IMF wrote in its latest quarterly World Economic Outlook, welcome news for the White House as it tries to boost growth, jobs and wages. Real gross domestic product (GDP) increased at an annual rate of 2.6 per cent in the fourth quarter of 2017, according to the “advance” estimate released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 3.2 percent.

Faster wage and economic growth is a reality across the developed world with the US at its vanguard. A byproduct is tightening of policy aggressively. Easy monetary policy is a relic of the past and, as with such cycles, debt may well trump equity going forward. This is precisely why the fear gauge is showing enormous volatility. The risks of inflation as pointed out by RBI on Thursday and inherent in the US currently due to an overheating economy mean that a recession is far away, for the trade cycle will see peaks rather than troughs.

‘Financial Times’ summed up the situation on Thursday when it stated - The high velocity termination of short volume funds worth over $3 billion was one technical factor implicated in the violence of S&P 500's drop. The whipsaw trades scything through the world of notional valuations, but equally real money in the real world, devastating people, markets and economies. What is reassuring is that banks are not disintegrating and falling by the wayside, nor is there sub prime mortgage crisis. India remains well insulated despite being plugging and playing in a well integrated global network. Glocal issues have been dominant - between a US contagion and old levies returning after 14 years to haunt equity investors. What is disquieting, though, is that bonds are a recurrent theme across financial markets and they may well trip one of the longest rip roaring bull runs in recent years. Let Edelweiss Financial Service have the last word in this debate - “With crude oil prices moving up last year, there is concern that inflation may rise and there is no certainty where crude prices may pause. Second, in the US, it is expected that rate hikes will be more aggressive this year. Bond traders are already sitting on losses and have no appetite to buy more in this market environment.”

Columnist: 
Sandeep Bamzai