While the recent rise in bond yields has been strong and sharp, it has not changed Citigroup’s bullish outlook for the equity market. Equities remain cheap in absolute and cheap relative to debt. “We need to see Pan European bond yields rise much further before equities look fair value relative to debt,†noted Citigroup analysts in a research note dated June 11, 2007.
Since the start of June, bond yields have increased sharply around the world. German 10-year yields are up by about 20 basis points, as are 10-year yields in the
The most recent increases in
The sell-off in the German bond market has been particularly meaningful over the last year. Supported by stronger economic data amongst other drivers, the German equity market has outperformed the bond market by 45% in the last 12 months (total return for the DAX over the last 12 months has been 42% vs -2% for the Bund). Those who have invested in bonds, and not equities, have missed out on some great returns.
Citigroup economists suggest bond yields are unlikely to head to previous low levels anytime soon. First, the recent increase in Citigroup’s ECB rate forecast suggests there will be more pressure on long bond yields from the short end. Citigroup economists believe the ECB will raise rates a further 25 basis points this year to 4.25%. Market expectations are for the ECB to raise rates a further 50 basis points by year end.
Second, our European economists recently noted the upside risks to real yields, driven by falling global spare capacity and rising investment spending.
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Consequences for equities
In an environment where bond yields remain at current levels, or could push even higher, what are the consequences for equities? More competition for equities, but still cheap
While the increase in yields makes fixed income securities more competitive relative to equities, Citigroup analysts don’t see yields at current levels being a major weight on the equity market just yet.
The 12-month forward earnings yield for the DJ Stoxx has moved closely with our calculation of a Pan-European government bond yield (40% Gilts, 60% Bunds) from 1992 to 2001. After 2001 the valuation relationship between bonds and equities broke down. Back then a sharp rise in the equity risk premium and a collapse in growth expectations could be blamed.
Bond yields continued to push lower until early 2006 when they yielded less than 4% for Pan Europe (4.2% for the
The most recent rise in yields may be the beginning of a re-alignment of the old relationship. Equities have provided very strong earnings growth over the last four years and are on track for another year of solid earnings. Fears surrounding growth expectations have been wrong. While the earnings yield has not changed much since early 2006, bond yields have increased some 120 basis points. For the old relationship to re-align completely we need to see government bond yields rise a further 250 basis points.
While government bond yields have risen, so have corporate bond yields. The average cost of credit in Pan-Europe, for a BBB issuer, has now increased to about 6% from 5.2% in December last year. While de-equitisers can borrow at around 6% they can buy European equities with a trailing earnings yield of 6.5% (or a forward earnings yield of 7.5%). The de-equitisers still benefit from a positive carry. However, the size of the carry has been squeezed
While the carry between the cost of credit and equities is being squeezed for the entire market, we find some significant differences within the equity market. For companies in the DJ Stoxx Large Cap index the 12-month forward earnings yield is 7.7%. This compares to a corporate bond yield of 6%, so the positive carry between corporate bonds and large-caps in Pan Europe is 170 basis points. It is much smaller for the mid-caps. The 12 month forward earnings yield for the DJ Stoxx Mid-Cap index is 6.3% — just 30 basis points more than the cost of credit.
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