Ten-year government bond yields in the US and Europe are edging

michael terry: stock mkt looks for a range of valuation, not a point, therefore double or triple bottom and top very often

Reading between the lines of bonds and shares
By Neil Hume

Published: August 27 2010 19:56 | Last updated: August 27 2010 19:56

“Equity investors are in for a rude shock. The global economy is sliding back into recession and they are still not even aware that these events will trigger another leg down in valuations, the third major bear market since the equity valuation bubble burst.”

That quote, from Société Générale’s famously bearish global strategist Albert Edwards, sums up the dilemma facing shareholders as they return from their summer holidays this year. Should they be listening to the bond market, where yields on government bonds are pricing in Japanese-style deflation and selling? Or should they hold their nerve?

EDITOR’S CHOICE
Professionals shown up by ‘dumb money’ - Aug-27.Retail investors resist siren call of equities - Aug-27.Hedge fund vehicles losing ground - Aug-27.On Wall St: Worry more about bond troubles - Aug-13.Treasury yields tumble on Fed move - Aug-11..Certainly, they could be forgiven for bailing out. Ten-year government bond yields in the US and Europe are edging ever closer to 2 per cent – the level Japanese government bond yields hit before consumer price deflation set in during the late-1990s.

The similarities with Japan do not end there. A debt bubble has just burst, short-term interest rates have been slashed to near-zero and central banks have turned to quantitative easing to prevent an even deeper recession.

But there are also differences, says HSBC strategist Garry Evans. Japan took nine years to cut interest rates to zero and 12 years to inject capital into its big banks. The Bank of Japan performed only limited quantitative easing, and that was not until 2002-03. So, it is possible, says Mr Evans, that the US and the developed world will not experience years of stagnant growth like Japan. If that is the case, then buying bonds and selling equities might not be a smart move. Indeed, the equity market is not currently pricing in Japanese-style deflation. If it were, Mr Edwards would be right and share prices would be a lot lower than they are now. As things stand, the FTSE 100 has fallen 4 per cent this year, even though the yield on 10-year gilts has dropped from 4.1 per cent to 2.9 per cent.

This divergence in bond yields and equity prices is at odds with the relationship that held for most of the past decade. Since 2000, what has been good news for bonds (sluggish growth and low inflation) has more often than not been bad news for equities and vice versa.

Citigroup strategist Robert Buckland says there are two possible explanations for this decoupling and the relative resilience of the stock market. One is the divergence between the real economy and company earnings. The second is the emergence of a new type of buyer of government bonds that is not selling equities: central banks.

While the bond market is tracking the slowdown in economic momentum from various leading indicators, the equity market is tracking company earnings. The recent reporting season in Europe and the US has been good, with analysts upgrading forecasts and companies reinstating dividends.

At the same time, government bond yields have been depressed by quantitative easing and the talk of more QE. “Perhaps low fixed income yields tell us less about economic prospects and more about technical buying of government bonds,” says Mr Buckland. Whoever is proved correct – the bond or the equity market – the fall in yields has certainly had some interesting side-effects. The recent flurry of corporate deals is in part due to the low cost of debt. BHP Billiton, for example, is paying just 3-4 per cent interest on the $45bn credit facility it will use to help fund its hostile bid for PotashCorp.

There are now more than 60 FTSE 100 companies whose shares yield more than 10-year gilts, according to Oriel Securities, while the 12-month forward dividend yield for the FTSE All-Share index is around 3.8 per cent and the trailing yield 3.4 per cent. “Even on a trailing basis, and assuming no growth in dividends, equities offer a 50 basis point yield premium to 10-year gilts,” says Oriel’s Darren Winder.

But that will not count for much if the bears are correct. When Japanese bond yields hit 2.5 per cent in 1995 the right thing to do was to keep on buying bonds and sell equities. By 2003 yields were at 0.4 per cent and the Nikkei had more than halved. [e-mail]
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