DSIJ explains: Why have equity markets weakened due to rise in government bond yields?
The recent sell-off and volatility in the global equity markets have been attributed to a rise in government bond yields. The rise in long-term bond yields has had a varied impact on different market indices. While the broader index i.e. US S&P 500 has declined by nearly 1.5 per cent since its recent February 12 high, the tech-heavy Nasdaq index declined by over 3 per cent since its high. The benchmark for the emerging markets i.e. MSCI EM index has declined by nearly 3.5 per cent from its mid-February high.
In India, the benchmark Sensex has dropped by over 4.5 per cent as of February 22, while the broader index, BSE 500 dropped by 3.5 per cent. This decline must be viewed against the backdrop of the rising government bond yields. The US 10-year benchmark bond yields have risen from 1.07 per cent at the end of January to a level of 1.37 per cent as of February 22, while the Indian 10-year government bond yields have increased from 5.95 per cent to 6.20 per cent over the same period.
One of the key parameters for the valuation of equity is the discount rate that is applied to discount (reduce) the value of future cash flows (cash profits) that a company will generate over the medium to long-term i.e. next 3 years or more. The discount rate, in turn, is driven by two factors namely, the long-term government bond yield (risk-free interest rate) and the extra return needed for investing in riskier investments like equity shares (equity risk premium).
While the equity risk premium can change over the short-term due to increased uncertainty in the stock market, the long-term government bond yield is influenced by three factors namely, the short-term interest rates that are set by central banks such as RBI, future inflation, and the future expectations regarding short-term interest rates . With short-term interest rates at a low level across the world, most experts believe that the recent rise in government bond yields is due to the expectations of higher future inflation.
Evidence of this higher future inflation expectation is the recent rise in commodity prices with one such benchmark namely, S&P GSCI index, which has increased over 12 per cent since the beginning of this month. The impact of the rising yields and related inflation expectations increase can impact different sectors of the stock market in a differing manner. Those companies that can offset the rise in the discount rate for their equity valuation by benefiting from the higher inflation with higher prices for their production will experience the rising stock prices (examples are Tata Steel & Hindalco where the stock price has increased over 15 per cent and 40 per cent, respectively since the onset of February).
On the other hand, companies from sectors where revenues are not expected to increase in the medium to long-term due to a rise in future inflation are negatively impacted by a rise in bond yields and related discount rates. The worst-affected equity is the long duration equity. Long duration equity refers to those companies whose valuations are driven by cash flows that the company will only earn over the long-term (i.e. 5 years or more). An example of this is Tesla, where the stock price has declined over 10 per cent since the onset of February.
Overall, the market indices, which are dominated by long duration equity, have been affected more (Nasdaq vs S&P 500) by the recent sell-off. The emerging markets including India have more long-duration equity (due to higher long-term growth expectations) and hence, have also been more affected.