Nervousness remains but the general sentiment is improving
World equity markets remained in correction mode also in the month of April. Although prices came off the lows, volatility still continued to be elevated and the markets experienced several large daily moves in both directions.
Still, last month was positive for most major equity markets. European markets shined last month, providing an almost 4.5% gain. Also the developed market equities in general did quite well, posting a 4.2% gain. Emerging market equities on the other hand were flat during that period and retained a small loss for the year 2018, being down 1.3% YTD. Developed market equities and the All Country World index in general both managed to regain all the losses and are currently flat for the year.
US 10-year yield rose over 3% for the first time in over 4 years
The interest rate movements became the main topic discussed by investors and moving the markets, even overshadowing the earnings reports. The brief movement of the US 10 year treasury yield to over 3% has received massive attention and actually spooked investors, sparking a sell-off in equities. The main reason for such investors’ reaction were the concerns that higher interest rates may hamper corporate earnings, while also making bonds relatively more attractive compared to equities.
US 10Y Treasury yield %
|Min %||Average %||Max %|
|10 last years||1.46||2.541833333||4.06|
Investors got used to low yields, as this was the first time in over four years that the 10-year yield crossed the 3% level. However, the average US 10-year yield was 3.5% since year 2000 and even higher 4.6% if we look at the longer period since 1990. Moreover, higher interest rates actually mean the market expects robust economic growth and moderate inflation, which is usually a perfect environment for equities.
Historically, in the four times that the US 10-year yield has crossed 3% from below, none provided negative performance in either 1 or 3 year horizon. On average, the 1 year US stock market increase after such event was 24.4% vs overall average of 6.1%. For the 3 year period, the average gain after yields crossed 3% was 53.5% compared to the overall average gain of 24.7%.
US 10 year Treasuries and S&P 500 index since 01.01.1962
|Average 1 year return||Average 3 year return|
|10-year rising over 3%||24.40%||53.50%|
|Whole period since 1962||6.10%||24.70%|
From the relative attractiveness perspective, though bond yield did increase, equities are still more attractive. The most common way to compare bonds and equities relative attractiveness, is to compare equity earnings yield to bond yield. Earnings yield is a reverse of the P/E ratio and shows how much investors earns in corporate earnings each year. For the US equities the forward P/E ratio is currently 16.1, meaning that US equities offer 6.2% earnings yield. European equities are even cheaper with a 14.4 P/E, which translates to 6.9% earnings yield. As a result, equities are still offering a hefty risk premium over bonds, making them continuously relatively more attractive. Moreover, bond yields still have much room for further increase, which would result in negative performance in the near term. Therefore, no major shift from equities to bonds should be expected.
Should flattening yield curve be a concern?
Another concern raised by investors was the flattening of the US yield curve, meaning that the difference between 10 year and 2 year yield is becoming smaller. Inverted or negative yield curve, when interest rates on the shorter-dated bonds are higher than the rates on the longer-term bonds is often considered as a sign of the upcoming recession. The latest study by the Federal Reserve Bank of San Francisco showed that negative yield curve predicted all the nine recessions in the US since the year 1955. Though, there is usually a lag of 6 to 24 month, between the signal and the start of recession.
US 10 year Treasuries, US 2 year Treasuries and S&P 500 index since 01.06.1976
|Average 1 year return||Average 3 year return|
|10-year yield minus 2-year yield declining below 0.5%||
|Whole period since 1976||
However, currently the yield curve is far from being inverted and there is no reason to think it will become inverted any time soon. Moreover historically, since the year 1976, when the 10 and 2 year interest rate spread reached the current level, it took on average 78.6 months till the start of the bear market in the US equities, with bear market being an over 20% price decline.
Moreover, current level of the yield curve was quite positive for the US equities historically in the 1 and 3 year perspective. In the one year period after the yield curve flattened to the current level, the US stocks gained on average 18.7%, which is double to overall average 1 year price increase. On the 3 year perspective, the picture is very similar, as the move to the current level of the yield curve was followed by an average US stock price increase of 53% compared to an overall average 3 year price increase of 30.6%.
To sum up, both from the perspective of economic theory and also historical data, neither the current level of the interest rate nor the yield curve pose any problems for global equities. On the contrary, such conditions tended to be fairly positive for the equities, at least in the medium term.
Corporate earnings are exceptionally strong this season
According to the last data available, US first quarter earnings are expected to increase 25.7% from the year before. So far, of the 409 companies in the S&P 500 that have reported earnings to date for Q1 2018, 79.2% have reported earnings above analyst already high expectations. What is more important, is that not only the bottom line is growing due to favorable effects from the tax reform, but also the revenues are expected to grow 8.4%. That confirms the strength of the global economy and suggest that earnings should continue growing also going forward.
Compared to Q1, 2017
The outlook still remains positive
All the prerequisites for the continuation of the equity uptrend are still intact: global economy is growing, monetary policy still fairly accommodative, inflation is benign and corporate earnings are growing and growth is expected to continue. Moreover, the exceptional optimism that appeared in the beginning of the year has disappeared due to the latest correction. And although the higher volatility and sideways price action may continue for some time still, the longer term uptrend in equities looks to be still in force.