Widening earnings-bond yield gap may weigh on stock market performance

If bond yields continue to climb, Nifty valuations will have to lower to maintain the gap

The widening gap between bond yield and the earnings yield may weigh on the stock market performance as it makes a case for lower equity valuations.

The sovereign bond yields on Monday breached 7.5 per cent for the first time in three years. The Nifty earnings yield is currently at 4.88 per cent. As a result, the yield gap has swelled to 2.62 per cent, up from 1.97 per cent in February.

Earnings yield is the inverse of the price-to-earnings (P/E) ratio. Therefore, as the P/E ratio expands, earnings yield reduces and vice versa. The lower the yield gap between bonds and equities, the more attractive it is to remain in equities. Meanwhile, a wider gap increases the appeal of debt instruments over equities.

In mid-January, when the Nifty recorded its 2022 peak of 18,308, its 12-month forward P/E had climbed to 25 times and earnings yield had slipped below 4 per cent. However, the index plunged as much as 14 per cent after that, helping the earnings yield climb to above 5 per cent. While on a standalone basis, earnings yield appears attractive, rising bond yields are dimming their appeal.

“The yield gap is still uncomfortably high versus historical levels,” said Sanjeev Prasad, managing director and co-head at Kotak Institutional Equities, in a note last week.
 

“There are four ways the gap can close — bond yields decline, which seems unlikely. Earnings yields increase through earnings upgrades, which also seems unlikely. Earnings yields increase over time (time correction) as the market discounts future earnings without the market moving much, this is still our base-case scenario. Or earnings yields increase through a decline in the market, this is a reasonably high-probability scenario, especially if inflation was to surprise on the upside,” he said.

Most analysts have lowered earnings expectations for FY23 because of the hit to metals and mining companies following the imposition of export duty on steel. Also, rising inflation has been eroding margins, weighing on earnings growth.

On the other hand, the yield on the 10-year government security–already up by more than 100 basis points (bps) this year–is expected to harden further as the Reserve Bank of India (RBI) and other global central banks tighten monetary policy amid accelerating inflation.

The 15-year average yield gap is 103 bps.

Assuming bond yields increase to 8 per cent, for the average yield gap to revert to the mean of 103 bps, earnings yield will have to improve to 6.97 per cent and Nifty valuations will have to reduce to 14.3 times. Or if the yield gap has to come down to a more reasonable level of 200 bps, the Nifty valuation has to still come down to below 17 times. Currently, the Nifty 50 Index P/E is 20.5.