Why rising bond yields are playing on stockholders’ nerves

THE FIRST full-length film made by Steven Spielberg features an unusual lead. So indeed does much of his more celebrated work. But the star of “Duel”, his 1971 debut, is nothing as exotic as a man-eating shark or cloned velociraptor. It is a tailgating lorry. In a nerve-shredding journey across the California desert, it torments a middle-aged salesman driving a rickety Plymouth Valiant. That its driver is faceless adds to the air of malice.

For investors in equities, bond yields are the juggernaut that looms menacingly in the wing mirror. Twice this year—first in February and again earlier this month—a jump in Treasury yields was followed by a sell-off in stockmarkets. There is reason for the jitters. A long bull market, driven in part by low interest rates, has left shares in America richly priced. And with interest rates still on the rise, nerves are rattled about the level of stock prices.

That is as it should be. By a crude yardstick, the reward to investors for holding risky stocks rather than risk-free bonds has fallen in recent years. The returns that stockholders can expect in future declined as stock prices rose. Meanwhile real interest rates have risen. The bond juggernaut is now tailgating; the stockmarket is losing momentum. The narrowing gap between bonds and stocks is grounds for anxiety, but not yet cause for alarm. It might call for a judicious tilt towards bonds in a balanced portfolio, but not much more.

Most of the time, the contrast between stocks and bonds is a blessing for investors. Each asset pays off when the other loses money. In recessions, when stock prices fall as profits are crushed, the expectation that interest rates will be reduced causes bond yields to fall. So bond prices rally (prices and yields move in opposite directions). In booms, by contrast, it is stocks that typically thrive and bonds that suffer. In this sense, stocks and bonds are complements.

But they are also rivals. If bond prices fall because of an expectation that real interest rates will be permanently higher, stock prices are likely to fall, too. That is because bond yields are the yardstick by which equity returns are discounted.

A good way to decipher the stocks-bonds link is to think about expected returns. Stocks are riskier than bonds. So owning them ought to come with a higher reward. A rough-and-ready gauge of expected stock returns is the earnings yield, the inverse of the price-to-earnings ratio. It is a measure of real returns—a burst of inflation that raised prices at a uniform rate would leave it unchanged.

The earnings yield on the S&P 500 index is currently 4.3%. That compares with a yield on inflation-protected Treasury bonds—a measure of expected real interest rates—of around 1%. The gap between the two, the equity-risk premium, is currently 3.3%.

Is that enough? History suggests not. According to a trio of academics, Elroy Dimson, Paul Marsh and Mike Staunton, over the very long haul, between 1900 and 2017, the excess real return of stocks over bonds in America has been 4.5% a year. In the recent past the risk premium has been quite a bit higher. As the euro-zone crisis came to a head in 2011-12, the proxy for the risk premium was above 8% (see chart). But you would expect a higher risk premium when the risks are greater. Now that the global economy is on a stronger footing, with America in particular booming, it is natural for the risk premium to fall.

And although it is lower, it is not dangerously low. In the 1990s, during the dotcom boom, the premium for owning stocks was negative. At that time real interest rates were a handsome 4%. Intelligent investors would obviously prefer a bigger margin for error than 3.3%. But they might also note that the gap between the earnings yield and real interest rates has been in a range of 3-4% for quite a lot of the past 20 years. If they want a better reason for owning equities, they must go beyond America’s shores. In the euro zone, for instance, bond yields on the safest government bonds are still negative. Meanwhile, the earning yield on the Euro Stoxx 50 index is an alluring 6.5%.

Bonds and stocks are still at a reasonably safe distance. But if bond yields rise further, or stock prices rise much faster than company earnings, the gap will narrow. In “Duel”, the road-race ends in a crash in which both lorry and car are destroyed. The salesman survives, a little shaken. In an imagined sequel, he buys a new car. He takes to the road, cautiously at first, but then with more confidence. Everything is fine. Until one day, in his rear-view mirror, he spots a lorry.

This article appeared in the Finance and economics section of the print edition under the headline “Reelin’ in the yields”