Bond yield rise may put pressure on stock valuations, rally in markets

Analysts expect up to a 10% decline in the broader markets due to these changes in global macroeconomic conditions

A steady rise in bond yields in the United States and India is likely to put pressure on the stock valuations and the rally in the markets, which have witnessed a sharp rebound from the March 2020 lows.

Historically, there is a negative correlation between the 10-year government bond yields and equity valuations.

The 10-year bond yield in the US is up 44 basis points (bps) since the end of July, and 75 bps since the beginning of the current calendar year. The 10-year US government bond had a yield of 1.67 per cent on Friday, sharply higher than the 0.92 per cent at the end of December 2020.

In India, bond yields are up 16 bps in the last three months, and 47 basis points year to date. The 10-year government bond ended Friday with a yield of 6.37 per cent, up from 5.9 per cent at the end of December 2020.

One basis point is one-hundredth of a per cent.

At the height of the Covid-19 pandemic, bond yields in the US had declined to a record low of 0.53 per cent in July 2020, while in India, yields had touched a low of 5.8 per cent in the same month.

“The post-pandemic rally in equities was fuelled by a sharp decline in bond yields and abundant liquidity that pushed valuations to record highs. This will now unwind as bond yields rise in the face of higher inflation. The yields may harden further if the US Federal Reserve tapers its bond purchase and starts raising interest rates as indicated,” said Dhananjay Sinha, MD and chief strategist, JM Financial Institutional Equity.  

He expects bond yields in the US to rise to 2.5 per cent by next year. That would translate into higher yields and interest rates in India as well. In the last 10 years, bond yields in India have been higher than in the US by 530 bps on average.

The majority of the gains in the Indian equity markets in the last decade came from the re-rating of stocks or higher valuations rather than higher corporate earnings. According to analysts, the re-rating was driven by a steady decline in bond yields, both in the US and India, that made it more profitable for investors to buy stocks rather than put their money in fixed-income instruments like bank FDs and bonds.

For example, the benchmark Sensex is up 206 per cent since the beginning of January 2013 but only 26 per cent of the gains came from a rise in the combined earnings of the index companies during the period; the rest came from an expansion in the index price to earnings multiple. 

The index’s underlying earnings per share is up just 75 per cent during the period, growing from Rs 1,113 at the end of January 2013 to Rs 1,946 on Friday. In the same period, the index P/E multiple expanded from 17.9 times at the end of January 2013 to 31.3 times on Friday. This, analysts say, makes the market vulnerable to a rise in interest rates globally and at home.

A sharp decline in interest rates in India and globally after the onset of Covid-19 was part of a long-term process that started after the 2008 global financial crisis. This trend is now reversing as inflation rises and analysts expect this to weigh on equity valuations.

Analysts expect up to a 10 per cent decline in the broader markets due to these changes in global macroeconomic conditions.

“There will be a macro adjustment in the equity markets as bond yields may harden further in response to higher inflation. The benchmark Nifty 50 could fall to around 16,500 levels in the next few months,” said Shailendra Kumar, CIO Narnolia Securities.

Others rule out a big correction in the benchmark indices and expect a rebalancing in the markets. “The benchmark indices will not fall more than 3-5 per cent but there could be re-balancing, where stocks with exorbitant valuations and those with high valuations but poor fundamentals will take most of the blow,” said G Chokkalingam, founder & MD, Equinomics Research & Advisory Services.