The yield on the 10-year Government of India bond (treasury yields) is at a seven-quarter high of 7.4 per cent, up from an eight-year low of 6.5 per cent at the end of December 2016. In this period, earnings yield declined to a decadal low of 3.3 per cent, from 4.1 per cent a year before (see chart).
Treasury yields could rise further, driven by higher inflation and more government borrowings. “Inflation is rising globally, driven by higher energy and commodity prices. Besides, the fiscal bonanza from a lower crude oil price is over, leading to higher government borrowings. The combined impact would be higher interest rates,” says G Chokkalingam, managing director of Equinomics Research & Advisory.
Earnings yield is the net profit for the past trailing 12-month period, divided by current market capitalisation (m-cap). Inverse of the price to earnings multiple (PE), it shows total yield to an investor if the company distributes its entire annual profit as dividend.
This analysis is based on the quarterly net profit and quarter-end m-cap of 339 of the BSE 500 index companies whose finances are available for the past 10 years.
Normally, say analysts, there is a positive relation between bond yield and earnings yield, as equity investors ask for higher yields (or earnings) to compensate for rise in treasury yield. “\A rise in bond yield signals a rise in interest rates, lowering the incentive to invest in equity unless compensated by faster earnings growth,” says Chokkalingam.
Corporate earnings growth, however, remains tepid. Combined net profit of BSE 500 companies was down 3.4 per cent on a year-on-year basis in the past 12 months, against a 36 per cent rise in their m-cap.
Experts point to benign liquidity conditions that allowed investors to ignore poorer earnings. “There was a secular decline in treasury yields after the 2007 Lehman crisis, as the world’s major central banks expanded money supply (or liquidity) to fight poor economic growth. In equity markets, this led to an expansion in PE (or lower earnings yields) and investors made money even without meaningful earnings growth during the period,” says Dhananjay Sinha, head of research at Emkay Global Financial Services.
The PE of BSE 500 companies has nearly doubled during the current rally, from an average of 14.1 during the June 2013 quarter to around 30 now. Earnings yield during the period declined from 7.1 per cent to 3.3 per cent.
The process is now reversing, as treasury yields are hardening globally. “Central banks are looking to normalise (or shrink) their balance sheet, leading to lower liquidity and higher interest rates. This will put a brake on multiple expansion or any further decline in earnings yield,” adds Sinha. In America, treasury yields are up nearly 90 bps, from a record low of 1.5 per cent hit in the June 2016 quarter.
This put the onus back on corporate earnings to equity return. “Earnings growth would (now) be central to any incremental rise in the markets.
While some growth is expected, we have to see if it will be enough to plug the widening gap between treasury yield and earnings yield,” says Sinha.