What do bond yields suggest to equity investors?

Morgan Stanley Research uses four bond market indicators to forecast equity market outcomes

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Sheetal Agarwal Mumbai
Last Updated : Jan 25 2013 | 5:33 AM IST

While bond market and equity indices are very different from each other, the yields are indicators of three key macro variables - namely - GDP growth, inflation and liquidity. All these factors are important influencers of corporate earnings, valuations and stock markets. Further, given the growing co-relation of Indian equity markets with global liquidity, overseas bond markets also can give crucial indications.

In its report dated 23rd October 2012, leading foreign brokerage house - Morgan Stanley Research tries to assess how to read the bond market indicators and what they are predicting for Indian Indices (see chart below). They have used four such indicators namely the value assigned to future growth, the traditional yield curve and two modified earnings yield gap approaches to extract information implanted in bond markets to forecast equity market outcomes (long term, mid-term as well as 12 month equity returns).

"The relative value is clearly perched in favor of equities over long bonds. Global liquidity is indicating a very bullish outcome for Indian shares. Domestic liquidity (i.e., local short rates) needs to improve further to make this a full-blown bull market in equities, if the bond markets are something to go by", the report states.

The Indicators…
Yield IndicatorWhat it indicatesWhat it predicts
Value assigned to future growthRelative value:equities vs bondsLong-term equity returns
Yield CurveEconomic Growth12-month forward equity returns
Modified Yield Curve using local short ratesDomestic liquidity relative to share prices3-year forward equity returns
Modified Yield Curve using US LongYieldsGlobal liquidity relative to Indian equity prices12-month forward equity returns

…And what they are saying about equities
Yield IndicatorWhat is it saying about equities right now?
 QualitativeQuantitative
Value assigned to future growthEquities are better valued than bonds10-year CAGR in returns at 15.7%
Yield CurveEquity returns likely to improve in the coming 12-monthsNA
Modified Yield Curve using local short ratesMid-term equity returns are likely to be middling. For fair level of returns, short term rates need to fall by 80 bps3-year CAGR in equity returns at 10%
Modified Yield Curve using US LongYieldsStrong returns over coming 12-months with high probability12-month equity returns at 49%

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First Published: Oct 25 2012 | 3:58 PM IST

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