Brett Sheather: Taking an interest in interest and bonds

The view changes, depending on who's looking through the telescope. Photo / Getty Images

This paper cynically suggested that one of the fundamental rules of stockbroking is that all news is good news. A couple of weeks ago we looked at a paper by the McKinsey Global Institute which noted that global interest rates were low and that, partly because of a substantial rise in investment in emerging market economies, global 10-year bond rates were likely to rise by at least 1.5 per cent.

That sounds bad but there is some debate as to whether rising interest rates are good or bad news for the sharemarket. We touched on this ambiguity in 2006 when we looked at an article by Andrew Smithers, an independent economist, who wrote a paper called "Stockbroker Economics". This paper cynically suggested that one of the fundamental rules of stockbroking is that all news is good news, and the name of the game is being able to convince clients to buy.

This is probably a bit unfair to stockbrokers, as all participants in the financial advisory industry need to sell something to make a living.

But making fun of stock brokers, financial planners and economists is great sport, and Smithers continues this great tradition.

He gave as an example of all news needing to be good news the fact that in times of recession, stock brokers point out that falling interest rates should theoretically drive up share prices. But they don't mention the fact that profits fall in a recession.

Similarly, when economies are booming, the sellers of financial services emphasise the stronger profits that will accrue to companies and ignore the associated higher interest rates.

So what is the story? Both scenarios certainly seem plausible enough. Some background might help.

In 1999, when former US Federal Reserve Governor Alan Greenspan was at the height of his popularity, the consensus was that falling interest rates were good for the stock market in that stock market valuations, as measured by the price-earnings ratio, tended to rise as interest rates fell.

Price-earnings ratios are quite easy to understand as they are simply the multiple of profits which a company sells for. So in a simple example, company A might earn $10 a year in profits and have 100 shares on issue, so its earnings per share would be 10c. If the company's share price is $1.50, then its price-earnings multiple is 15 times - that is, $1.50/10c. Easy.

What this theory says is that PE ratios increase as interest rates fall, and vice versa.

This is significant because PE ratios are quite volatile and in the past 60 years the average PE ratio of the US stock market has been as high as 60.7 and as low as 7.19.

This theory probably owed its then-popularity to the fact that US long-term interest rates had been on a continual long-term downward trend since about 1980, and the stock market had been rising more or less continuously over the same period.

In 1980 the PE ratio of the S&P 500 was 9.16. In 1999, it had risen to 30.5. In the same period the 10-year bond yield had fallen from 13.3 per cent to 6.5 per cent.

The reason people expect price-earnings ratios to go up is a bit complicated but it is basically because, as we know, any asset is just worth the cash flow that it produces discounted at an appropriate rate.

The appropriate rate is derived from the 10-year bond yield. So the lower the 10-year bond yield, the lower the discount rate and the higher the economic worth of a company.

This sounds sensible. But Philip Coggan, writing in the Economist, disagrees, pointing out that lower bond yields reflect changes in growth or inflation expectations, which should also lead to lower profit growth.

Similarly, a rise in bond yields should reflect a better growth outlook or higher inflation and thus higher expected profits.

Confused? That's not surprising. But last month an analyst from French bank Societe Generale shed new light on this conundrum. His paper, "Bond yields and equities: myths and realities", suggests there is no historical evidence that rising interest rates are a consistently negative factor for sharemarkets.

However, he found that whether or not interest rates are good or bad for the stock market depended on the level of interest rate.

Specifically, using European data, when 10-year bond yields are below 5.2 per cent, shares and interest rates go up together.

In this scenario, inflation is low and rising interest rates reflect strong growth, or a move away from deflation, both of which are good for shares. But when interest rates are above 5.2 per cent and rising, shares tend to fall, and the more they rise the worst it is for shares.

The Societe Generale analyst explains this negative correlation by saying that in this scenario, inflation is higher than the authorities would like and shares fall because the market is worried that monetary conditions will be tightened.

The good news is that the bank doesn't see German 10-year bond yields exceeding 3.2 per cent by the end of this year so, even if they rose by the 1.5 per cent forecast by McKinsey, they would still be under the magical 5.2 per cent figure.

It is interesting to look at the relationship between the local 10-year bond yield and the level of our stock market.

Until about 1986, the stock market rose with bond yields. After that point the stock market at first fell as interest rates fell, but gradually took off as interest rates fell further and stabilised.

What does this mean, if anything, for New Zealand retail investors? The honest answer is probably nothing. But it shows that the stock market rose strongly from 1970 to 1985, increasing in value by 14 times over that period, a compound growth rate of 20.3 per cent a year.

This might sound fantastic, but we shouldn't get too excited as inflation was a bit of a problem over that period, averaging 12.2 per cent a year. In the same period, 10-year bond yields took off - responding to the high inflation - rising from about 6 per cent in 1970 to peak at 18 per cent in 1985.

We all know what happened next - the 1987 crash occurred, sending the New Zealand stockmarket down to a low in 1990 some 64 per cent below its peak.

Although it felt like the end of the world at the time, and the 1988-89 period was a bad time to be a stockbroker, after 1987 the Reserve Bank gradually got inflation under control and 10-year bond yields fell steadily to around the 6 per cent level where they have more or less stayed.

The stockmarket, after bottoming in 1990, has been on a sharp upward trajectory, albeit with a correction in 2008, as it appears to be comfortable with 10-year bond yields at the 6 per cent level.

The New Zealand market, including dividends is today 137 per cent above its 1987 peak.

Perhaps one thing to observe is that the stock market might be at risk if 10-year bond yields broke decisively above the 6 per cent level.

There is good news here, however, from Dominick Stephens, senior economist at Westpac Institutional Bank, whose forecast for the 10-year bond yield to 2020 is 6 per cent.

If this is correct, interest rates should not pose too much of a threat to the local stock market in the next 10 years.

Brent Sheather is an Auckland authorised financial adviser. His adviser/disclosure statement is available on request.