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ECB's new deputy chair and rising bond yields

23 February 2018

Will the direction of the ECB be affected by the appointment of its new deputy chair?

This week it was announced that Luis de Guindos, the Spanish economics minister, will be appointed as the new Vice President of the European Central Bank (ECB) under Mario Draghi. Luis de Guingos worked at Lehman Brothers prior to his career in politics.  As a member of the Spanish government, he has been critical of Catalonia's attempts to break from Spain and the economic impact this would have.  With an Italian and a Spaniard at the top of the ECB, they are likely to be sympathetic to the plight of Southern European countries and policy is unlikely to change now.  However, Draghi's term of office ends next year and this appointment makes it more likely that a German, or someone from a Northern European country, gets the top job next year. This may lead to a more hawkish stance from the ECB in years to come.

Therefore, no real change in direction at the moment but Draghi's replacement next year is likely to be more contentious.

At what point do rising bond yields start to negatively affect the stock market rally?

The US Federal Reserve (Fed) has raised rates five times since 2015 with, apart from the very first move, little impact on equity markets. The market was well prepared for these rises and while bonds have gradually sold off to reflect higher yields, equities rose to new highs in January. The market was spooked in January by fear that inflation and interest rates would rise faster than the Fed predicted.  This was compounded by technical trades that caused the market to selloff by about 10%.  Since then, markets in general have stabilised and though they are not back to their highs, they have recovered some of the losses.

Equity prices can be seen as representing a stream of cash flows discounted back to the present day. The discount rate applied therefore impacts the price of the equity. If a higher interest rate is applied, the present value is reduced. Rational market prices should hence be derived from interest rates and expected earnings.  When doing this calculation, it is the long-term interest rate that is important. As such, as bond yields rise, equities look less attractive. A simple measure of equity value is the price to earnings ratio (P/E ratio). When this is low relative to interest rates, equity markets may rise in what is known as a multiple expansion.  Some commentators say that equity multiples look expensive relative to history, however the history they are looking back at is a time of higher bond yields.  In a low yield environment, a higher multiple may be justified.  In the last year, we have seen bond yields rising but earnings have been rising in many places by more than 10%. This compensates for the rate rise and allows equities to move higher.  Steep rises in interest rates may reduce earnings for highly levered companies but improve earnings for banks who traditionally take short-term deposits and lend longer term.

In future, interest rates are likely to be well flagged and against a strong economic background with corporate earnings increasing, the market can continue to flourish.  The prospective P/E for the S&P 500 index of US stocks is 17.  If inverted, it gives an earnings yield of around 6% which still looks a lot better than 3.2% for a 30 year US Treasury, particularly if there is a prospect for growth.  However, we should remember that as equity prices rise, they are more risky and are sensitive to changes in sentiment.  In a steadily rising market, volatility may be low but risk is getting higher.  When the market falls 10%, the headlines are bad and mathematical risk measures such as volatility are higher. However, we must remember that all other things being equal, a market that is down 10% is cheaper and although it might not feel like it, less risky to invest in.





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