- While low bond yields certainly do make equities more attractive relative to bonds, this is entirely because they make bonds particularly unattractive.
- Over 100 years of U.S. data and current European data show that interest rates have little baring in current equity valuations or subsequent equity performance.
- Investors have historically required high absolute returns on stocks regardless of bond yields due not just to high volatility but their tendency to weaken at the worst possible times.
- The combination of expensive valuations, weak real GDP growth, and rising inflation risks suggests large equity declines are coming which will result in negative total returns over the next decade.
Investors continue to believe that the current low bond yield environment justifies the elevated level of valuations in U.S. stocks to some degree or another. Some investors seem to believe that low current bond yields justify positive future returns despite expensive valuations, while others suggest that they will at least prevent significant declines. Both are views are deeply flawed, particularly as low rates partially reflect weak prospects for economic growth.
The combination of extreme valuations, weak real GDP growth, and rising inflation risks condemn the SP500 to painfully weak long-term returns regardless of current or future bond yields. We expect the coming years to include a series of sharp declines of the kind we saw in March, and investors who ride out these declines will still likely end up worse off in 10 years’ time even in total return terms.
The Data Shows Low Rates Have Little Impact On Equity Valuations
We hear daily how low yields justify high equity valuations because ‘equities compete with bonds’ meaning that as investors have to put their money somewhere, lower interest rates mean that equities become more attractive which should therefore support valuations. However, there is zero evidence to support such claims. While low bond yields certainly do make equities more attractive relative to bonds, this is entirely because they make bonds particularly unattractive.
The following chart shows U.S. 10-year bond yields versus equity valuations going back to 1880, using the cyclically adjusted PE ratio. Low yields have clearly had very little correlation with current equity valuations. The only slight inverse correlation between yields and valuations results from the late-1970s-early-1980s period.
Correlation Between Bond Yields And Equity Valuations
Source: Bloomberg, Robert Shiller
The next chart shows U.S. 10-year bond yields versus subsequent 10-year nominal returns over the same period. Again, there is little correlation between the two apart from the slight positive results from the late-1970s-early-1980s period.
Correlation Between Bond Yields And Equity Returns
Source: Bloomberg, Robert Shiller
The strong returns that occurred from during the high rate period of the 1970s and 1980s has nothing to do with the fact that interest rates were high, and everything to do with the fact that valuations were low. This is shown below with the close correlation between the CAPE and subsequent 10-year returns.
Correlation Between Equity Valuations And Subsequent Returns
Equity Risk Premiums Are About Much More Than Bond Yields
The post-War nominal total rate of return on the SP500 has averaged around 10%, which breaks down roughly into 3% income from dividends, 6% price appreciation from dividend growth (which has tracked nominal GDP growth), and a 1% decline in the dividend yield as it has fallen to 2% from its long-term average of 3%. Over this period, the 10-year bond yield has averaged around 5% meaning that the equity risk premium – the premium that investors have required to hold stocks over bonds has averaged 5% (10% total return – 5% bond yield).
It is tempting to think that with the ~4 percentage point drop in bond yields from the historical average of 5% to the current 1%, this means that the required rate of equity returns has fallen from 10% to 6%. However, if nominal GDP and dividends were expected to grow at their historical average of 6%, this would make the SP500 infinitely undervalued as the dividend yield required to achieve 6% returns amid 6% growth is zero.
The fact is, declining bond yields do not have a very strong relationship with the equity risk premium. Investors have historically required high absolute returns on stocks regardless of bond yields because equities are risky assets. Not necessarily because they are volatile, although this is part of the reason, but primarily because they are volatile to the downside at the worst possible time. Equity investors require high returns because when the economy heads to recession they do not want to suffer from a decline in equity prices at the same time as they are suffering from a decline in dividend income and potentially employment.
Low Interest Rates Partially Reflect Low Nominal Growth Prospects
It follows from the above that a key reason why low bond yields do not justify extreme valuations is that they often reflect weak prospects for nominal GDP growth. While the Fed has engaged in activist monetary policy to try to drive a wedge between bond yields and nominal GDP growth, the long-term correlation remains broadly intact. If the current low yield environment reflects a weak nominal GDP growth outlook, as we believe is the case today, then no current elevation in valuations is justified at all. Furthermore, subsequent returns will tend to be weak even if valuations remain elevated.
Source: Bloomberg, BEA
Even if we assume generously that U.S. equity investors require a 5% premium to invest in stocks over 10-year bonds regardless of the bond yield, the 1% current bond yield likely reflects the belief among investors that nominal GDP growth will also average around 4pp below its long term average.
This means that in order for total returns to reach 6% total returns (5% equity risk premium + 1% bond yield) amid a 2% dividend yield and 2% growth, equity valuations would have to half so that the dividend yield rises to 4%. If, on the other hand valuations were to remain at elevated levels reflected in a 2% dividend yield, investors would receive only see 4% nominal total returns.
High Nominal GDP Would Require Rising Inflation, Undermining Valuations
As we argued here and here, we expect real GDP growth to average 0-1% over the next decade when measured from the 2019 peak, in part due to the very fact that interest rates have been kept so low for so long, undermining productivity and savings rates. This means that if nominal growth is to be significantly higher than long-term bond yields, thus ‘justifying’ current elevated equity valuations, inflation will have to rise rapidly, which itself would likely undermine equity valuations.
Source: Bloomberg, Robert Shiller
We have every reason to expect inflation to rise over the coming years and have detailed our inflation concerns here and here, but this is no reason to expect equity valuations to remain elevated. The problem with holding U.S. stocks because inflation will rise is that rising inflation environments have typically been very poor times to invest for two fundamental reasons: Firstly, as the above chart shows, high inflation has been associated with low valuations with shifts from low to high inflation environments therefore resulting in very weak nominal returns as valuation declines more than offset rises in nominal earnings. Secondly, high inflation tends to be a reflection of weak real GDP growth as the chart below shows, which is negative for real corporate profit growth.
Correlation Between Inflation And Real GDP Growth
Source: Bloomberg, BEA
What About If Inflation Rises And Interest Rates Stay Low?
One counterargument could be that the reason rising inflation has been hostile to stocks in the past is that interest rates have risen in tandem, but what if this time around the Fed keeps rates low even as inflation pressures rise? Theoretically this would allow nominal GDP growth to far outstrip bond yields, keeping the discount rate low and justifying high valuations and solid returns.
However, if we look at the case of equity valuations across other developed markets, deeply negative real interest rates have done nothing to prevent weak returns over recent years and cheap valuations currently. European and Japanese stocks have had much lower real interest rates than the U.S. over recent years and still significantly underperformed. U.K. and German stocks, for example, currently trade at less than half of U.S. valuations despite having real yields roughly a full percentage point below the U.S.
U.S. investors who have been enticed by low rates to hold overvalued stocks will of course argue that the outlook for earnings growth in Europe is much weaker compared to the U.S. This may be the case, but if low real interest rates really are supportive for equity valuations, current valuation differentials suggests that the U.S. economy will boom while Europe goes back to the Dark Ages.
Expensive Valuations, Weak Real GDP Growth, And Rising Inflation Suggest Major Equity Declines
If we assume that the U.S. is different the rest of the world, discard 100+ years of U.S. data and current data from other developed markets, ignore the weak outlook for real GDP and the strong tendency for equity valuations to fall sharply in the event of rising inflation, I suppose there is a case to be made for U.S. stocks over the long term. In the best case scenario real GDP growth will exceed 1% while inflation will rise substantially but gradually, allowing nominal GDP and dividend growth to match their historical average but preventing the need for the Fed to normalize rates. This would still likely see equity returns underperform long-term averages.
A much more likely scenario is that real GDP growth averages closer to zero while inflation pressures enter a volatile uptrend causing the Fed to at the very least tone down its all-out effort to support asset prices. Valuations mean revert towards long-term averages through a series of sharp declines of the kind we saw in March, leaving investors who ride out these declines worse off in 10 years even in total return terms.