Beware distortion in yield curves and discount rates.

Last week was certainly a jittery one in equity markets, but in bond markets history was being made.

The yield on Germany’s 10-year government bond went negative for the first time ever. A Swiss government bond set to mature 32 ½ years from now also saw its yield go red. Bank of America Merrill Lynch offered a chart showing global interest rates hitting their lowest levels in 5,000 years.

What happens in the world of fixed income matters a lot to equity portfolio managers: It gives us valuable signals about what’s going on in the macro environment, and hence the potential for companies to grow revenues and earnings; and by providing us with discount rates it directly influences how we value those potential earnings.

So what are these historic numbers telling us today?

‘Brexit’ Risk Has Jolted Markets…

On the macro side there was certainly a bout of risk aversion last week. As bond yields plummeted, gold rallied to test the $1,300/oz. level. Last Monday the VIX Index rocketed from 17 to 23.

Much of this seemed to come down to a spate of opinion polls showing momentum for the “Leave” camp in the U.K.’s referendum on membership in the European Union. Brad Tank, Erik Knutzen and I will discuss the longer-term implications of that vote in a special edition of CIO Weekly Perspectives this Friday, so keep an eye out for that.

… But Equities Are Still in a Rally

For now, it’s enough to point out that this binary risk may well be priced back out of markets by this time next week. In the meantime, while bonds trade with historic low yields, U.S. equities are still only down around 2.5% from their recent high, itself close to an historic level.

How do we make sense of these apparently contradictory market signals? Is one of them spectacularly wrong in its growth forecast, and if so, which is it—the bond market or the equity market?

This is the wrong question to ask in the post-financial crisis world. Instead we should ask about the extraordinary forces causing these fixed income records to tumble.

U.S. Curve Shaped by Fed and Non-U.S. Investors

Take the shape of the yield curve, for example. A flat or inverted curve tends to make investors anxious: A flat or inverted spread between the two-year and 10-year U.S. Treasury yield has been quite a reliable forward indicator of a U.S. recession over the years.

Today that spread is around 90 basis points. A year ago it was as steep as 175. But this move has been not only, or even mainly, about investors reducing their long-term growth expectations. Indeed, part of it has been a move upwards at the short end of the curve as the Federal Reserve has talked about normalizing the Fed Funds rate in response to the U.S. economic recovery.

At the long end, rather than a new sense of economic gloom, yields have declined due to demand from investors in the Eurozone and Japan, where rates are low or even negative. In comparison, long-dated U.S. Treasuries look relatively attractive. There is simply a shortage of high-quality yielding assets in the world.

In short, we shouldn’t assume that bond markets are forecasting a hostile environment for equities.

Low Discount Rates Make Equities Look Expensive

We should also think about how low risk-free discount rates affect our views on equity valuations. Through the simple mathematics of discounted cash flow models, lower discount rates lead to higher P/E ratios for the same level of future earnings. Higher levels of inflation and interest rates are one important reason why the average P/E ratio for the S&P 500 Index was around 15x from the 19th century until 2007, and 16.5x between 1950 and 2007. In the type of low-rate environment we have experienced in more recent years, the average has been 17-19x.

To be clear, we still caution that current equity market valuations represent optimistic expectations for earnings growth over the next 12 months—but we do not think they represent “irrationally exuberant” expectations, as a cursory look at relative value versus bonds might suggest. Bond markets still provide useful signals to equity portfolio managers, but we need to be clear about what they are—especially when those markets rewrite the history books as vigorously as they are at the moment.

In Case You Missed It

  • U.S. Retail Sales:  +0.5% in May
  • U.S. Producer Price Index:  +0.4% in May month-over-month and -0.1% year-over-year
  • Federal Open Market Committee Decision:  The FOMC made no changes to its policy stance
  • NAHB Housing Market Index:  +2 to 60 in June
  • U.S. Consumer Price Index: +0.2% in May month-over-month and +1% year-over-year (core CPI increased 0.2% month-over-month and 2.2% year-over-year)
  • Eurozone Consumer Price Index:  +0.4% in May month-over-month and +0.8% year-over-year
  • U.S. Housing Starts:  -0.3% to SAAR of 1.16 million units in May
  • U.S. Building Permits:  +0.7% to SAAR of 1.14 million units in May

What to Watch For

  • Wednesday 6/22:  U.S. Existing Home Sales
  • Thursday 6/23:  U.S. New Home Sales
  • Thursday 6/23:  Brexit Referendum - U.K. vote on its membership in the European Union

– Sonia Mukherji, Investment Strategy Group

Statistics on the Current State of the Market – as of June 17, 2016

Market Index WTD MTD YTD
S&P 500 Index -1.1% -1.1% 2.4%
Russell 1000 Index -1.1% -1.1% 2.4%
Russell 1000 Growth Index -1.3% -1.4% 0.3%
Russell 1000 Value Index -0.9% -0.7% 4.6%
Russell 2000 Index -1.6% -0.8% 1.5%
MSCI World Index -1.7% -2.2% -0.1%
MSCI EAFE Index -2.8% -4.2% -4.9%
MSCI Emerging Markets Index -2.1% 0.1% 2.5%
STOXX Europe 600 -2.5% -5.1% -5.8%
FTSE 100 Index -1.5% -3.1% -1.4%
TOPIX -6.0% -9.3% -18.3%
CSI 300 Index -1.6% -1.6% -16.1%
Cash & Fixed Income      
Citigroup 2-Year Treasury Index 0.1% 0.4% 1.1%
Citigroup 10-Year Treasury Index 0.2% 2.0% 6.7%
Barclays Municipal Bond Index 0.4% 1.1% 3.9%
Barclays US Aggregate Index 0.1% 1.0% 4.5%
Barclays Global Aggregate Index 0.3% 2.3% 8.3%
S&P/LSTA U.S. Leveraged Loan 100 Index -0.5% -0.2% 5.4%
BofA Merrill Lynch U.S. High Yield Index -0.7% 0.2% 8.3%
BofA Merrill Lynch Global High Yield Index -0.8% 0.4% 8.1%
JP Morgan EMBI Global Diversified Index -0.4% 1.2% 8.0%
JP Morgan GBI-EM Global Diversified Index -0.8% 2.4% 10.3%
U.S. Dollar per British Pounds -0.2% -1.8% -3.0%
U.S. Dollar per Euro -0.4% 1.0% 3.5%
U.S. Dollar per Japanese Yen 2.5% 6.3% 15.4%
Real & Alternative Assets      
Alerian MLP Index -0.8% 1.6% 10.9%
FTSE EPRA/NAREIT North America Index 1.0% 2.3% 8.3%
FTSE EPRA/NAREIT Global Index -0.8% 0.6% 5.4%
Bloomberg Commodity Index -0.2% 4.0% 13.1%
Gold (NYM $/ozt) Continuous Future 1.5% 6.3% 22.1%
Crude Oil (NYM $/bbl) Continuous Future -2.2% -2.3% 29.5%

Source: Factset, Neuberger Berman LLC.