A debate that has been raging across Wall Street for the past few months is the question of whether or not low bond yields justify higher stock prices. The roots of this argument are to be found in the equity risk premium and the Fed Model, two equity valuation models that rely heavily on bond yields (risk-free rate) to produce a fair value calculation for stocks.
Deutsche Bank’s analysts were some of the first to draw attention to the idea that stocks could go much higher if bond yields continue to decline earlier this summer.
At the beginning of July, Deutsche Bank’s Dominic Konstam and team wrote in a research note that over the past 30 years the equity risk premium between the S&P 500 and 10-year Treasury is around 2% and today, the premium is still some 2% higher than this historical average. Based on the idea that at some point in the future the equity risk premium will revert to the mean, Deutsche Bank’s analyst went on to estimate that the S&P 500 could rise another 200 points from current levels to make up this difference.
Low-interest rates also justify lower discount rates. When the discount rate goes down the future cash flow stream provided by common stock dividends goes up in value, increasing intrinsic value and, in theory, the price an investor is willing to pay to get their hands on the security.
Barclays’ US Equity Strategy analysts Jonathan Glionna and Eric Slover disagree with this view, and they laid out their opposing argument in an equity research note sent out to clients on Wednesday.
Lower interest rates don’t necessarily mean higher equity prices
There are two key issues Barclays’ analysts have with the interest rate equity case. Firstly, the team questions the ability of models to estimate equity prices accurately. Indeed, according to Barclays’ dividend discount model, a 100 basis point decline in the yield on the 10-year Treasury suggests the value of the S&P 500 goes up by 64%. Conversely, if the yield on the 10-year increased by 100bps, the value of the S&P 500 falls by 34%. Clearly, this relationship does not exist, and if it did, it’s highly likely few if any investors would be willing to take on this risk.
Secondly, there’s the issue of the low growth environment the world is currently trapped.
Historical models assume that dividends and revenue will continue to grow at historic rates. Dividends have increased at an annual rate of more than 6% for the last 70 years, but the outlook for inflation and real GDP suggest that potential dividend growth going forward may be less than 3.5% — largely due to the decline in inflation. Moreover, inflation alone has explained most of the dividend growth achieved by the S&P 500 over this period. Even with interest rates at the lowest level in history, central banks are struggling to stimulate inflation so are low rates really going to propel equity prices higher when dividends are falling?
On top of this argument, Barclays highlights that in the past, the decline in risk-free rates is often offset by an increase in the equity risk premium. Until the financial crisis, it was generally the case that interest rates declined as economic growth slowed and the equity risk premium expanded as owning equity in a hostile economic environment became riskier. This trend longer exists.
All in all, the team at Barclays concludes:
“Many of the arguments that suggest that lower bond yields should result in higher stock prices sound plausible. Upon examination, however, we fail to be convinced. Yes, a lower discount rate should increase the present value of future cash flows and therefore dividend discount models should produce higher results. But the growth side must also be adjusted and with inflation and real GDP growth slow it is just as easy to construct a dividend discount model that suggests the S&P 500 is expensive. In addition, fund flows seem to follow returns and not changes in interest rates. The total return achieved on bonds goes up when yields fall, pulling more money into the asset class, rather than pushing it away. Lastly, we fail to find the international examples that suggest lower interest rates have caused a sustainable re-rating higher for equities [Japan].”