Rising Bond Yields
We thought this year would be okay for shares as inflation would likely fall and recession would likely be avoided. So far so good, although Australian shares have been poor. But the big surprise has been a resumption of the rise in bond yields from April which has taken Australian bond yields to their highest since 2011 and US bond yields to their highest since 2007.
This has been mainly due to stronger than expected economic activity keeping interest rate expectations elevated (with the Fed and other central banks flagging that they will keep interest rates “high for longer”), along with the deteriorating US fiscal situation and increased bond issuance and Japan relaxing its limits on its bond yields.
Now, the back up in bond yields this year – being based more on stronger than expected growth and hopes of a soft landing – is less threatening for shares than was the rise in bond yields into last year, which was more driven by rising inflation. But it’s still putting big pressure on share market valuations as highlighted by the deteriorating risk premium that shares offer over bonds.
This is proxied in the next chart by the earnings yield on shares (12 month ahead consensus earnings expectations divided by share prices) less the 10-year bond yield. It has fallen to its lowest in over 20 years in the US, and in Australia to its lowest since 2010.
Feeding into the mix are another bunch of concerns including:
- the still high risk of recession in the US;
- sluggish growth in China and worries about its property sector;
- messy US politics with Republicans beholden to a small group of fiscal conservatives seeing the removal of the House Speaker, a high risk of a government shutdown next month & uncertainty over fiscal policy;
- a surge in oil prices on the back of production cuts by Saudi Arabia and Russia, with fears this will be made worse by war in Israel.
So far, shares have been relatively resilient. However, the risk of further weakness remains. Naturally in times of uncertainty it’s tempting to look at past periods of major market falls. The GFC (which saw 50% or so falls) is still fresh but there has been no similar build up in risk in debt markets as there was with the US housing/subprime boom into 2007. Similarly, unlike the dot-com/tech boom of the late 1990s that led to the tech wreck (again with 50% or so falls in global shares) US tech stocks are now making good profits. But some do see parallels with the 1987 share crash.
1987 – What Happened?
From mid-1982 to August/September 1987 global and Australian shares experienced a powerful bull market. This came on the back of recovery from the early 1980s recession and optimism about the economic de-regulation and reform of the 1980s and a re-rating of shares on the back of the move to lower inflation.
By 1987, this had become very speculative and debt fuelled with Australian shares nearly doubling over the year to their September 1987 high on the back of strong gains in so-called entrepreneurial stocks (e.g. Bond Corp and Qintex).
Shares peaked in August/September 1987 and after a gradual drift lower plunged on 19 and 20 October, resulting in an ultimate top to bottom fall of 35% in US shares and 50% in Australian shares. It took the US share market just over two years to rise above its pre-crash highs but Australian shares did not get there until February 1994.
The precise causes of the 1987 crash have been subject to much debate. But the key driver appears to have been a combination of a 3% rise in US inflation, a two percentage point rise in US bond yields and Fed tightening hitting investor confidence at a time when shares were very overvalued after huge gains and investor confidence was unsustainably high.
The following tables provide a comparison of key indicators for US and Australian shares today with those of 1987.
As in the months before the 1987 crash, the Fed has been raising interest rates and bond yields have been moving higher. But over the last few months, share markets have drifted down but remain relatively calm as occurred initially after the highs back in 1987. Fortunately, there are some big differences compared to 1987:
- Shares have seen far smaller increases compared to the run-up to the 1987 crash – there has been no 1987 style euphoria;
- Forward price to earnings ratios are higher than in 1987, particularly in the US, but inflation and bond yields are both lower such that the gap between forward earnings yields and bond yields is far more attractive than it was in 1987. See also the second chart in this note; and
- After the 1987 share market crash circuit breakers were built into the US stock market that close it down for a short period after a certain fall to help calm investors down.
However, while the lack of prior euphoria and more attractive valuations relative to bonds than in 1987 are positive signs, share markets are at risk of a further correction in the near term. The combination of the high risk of recession, uncertainty around the Chinese economy, US politics going from bad to worse with the removal of the House Speaker McCarthy and the threat posed by higher oil prices and renewed conflict in the Middle East all suggest the risk premium offered by shares over bonds should be higher than it is now, which in turn implies a high risk of more downside for share markets unless bond yields pull back sharply.
Investor sentiment has fallen sharply from the optimism seen mid-year when goldilocks was all the rage but it’s still not yet at the levels often associated with major market bottoms. See the next chart for the US. All of this suggests that the path of least resistance for shares may still be down in the short term. While valuations for the Australian share market are more attractive it would likely follow any further correction in US shares.