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The Indian equity markets have been treading lower for the past few weeks, after touching a lifetime high on July 20. The BSE Sensex has closed in the red in seven of the past nine-trading sessions and following Wednesday’s sharp decline, the benchmark index is now down 2.6 per from its record high of 67,572.
One of the factors driving down stock prices on Dalal Street is the shrinking spread between the earnings yield on Indian equities and the yield on 10-year US government bonds.
The spread between the Sensex earnings yield and the 10-year US government bond yield is now almost zero, against 0.34 per cent at the end of December 2022 and 1.74 per cent in July last year. The current spread is the narrowest in 187 months. Historically, the spread between earnings yield and the US benchmark treasury bond yield has mostly been in positive territory.
A zero or a negative spread was last seen in the last quarter of the calendar year 2007 and early 2008, ahead of the big crash in stock prices in 2008.
The Sensex had an earnings yield of 4.01 per cent on Wednesday, the same as the yield on the 10-year US government bond (4.12 per cent until 8.30 pm IST). This provides little or no financial incentive for foreign portfolio investors to put money in Indian equities, rather than risk-free US treasury bonds.
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A stock earnings yield is inverse of the price-to-earnings multiple and is a hypothetical dividend yield for an investor if the company distributes 100 per cent of its annual profit as equity dividends. And, lower the stock price-to-earnings multiple, the higher the earnings yield. A Higher earnings yield means a greater arbitrage for investors over investment in risk-free and fixed-income instruments, such as government bonds and bank fixed deposits.
The spread between the Sensex earnings yield and the 10-year US government bonds is crucial as the rally on Dalal Street is largely driven by inflow from foreign portfolio investors (FPIs). The current weakness in the equity markets has been accompanied by a sell-off by FPIs.
The sharp decline in spread is due to a decline in earnings yields in the Indian equity market, along with a rise in bond yields in the US. The Sensex earnings yield is down 20 basis points in the past 12 months from 4.31 per cent at the end of August 2022. In the same period, the yield on 10-year US government bonds is up 92 basis points from 3.2 per cent at the end of August 2022.
This has made the Indian equity markets less attractive to foreign investors. “The equity valuation in India is nearly 50 per cent higher than the average valuation of 26 global markets. This is now driving an underperformance of the Indian equity markets in an environment of hardening bond yields in the US,” said Dhananjay Sinha, head-research and equity strategy at Systematix Institutional Equity.
Many analysts now see a further rise in US Treasury yields after a rating downgrade by Fitch Ratings. This may lead to a decline in risk assets, including emerging market assets. This is another headwind for Indian equity markets if earnings yields stay at current levels.
