Published on – 06-June-2020

The equity markets around the world have rallied in last couple of weeks including India; defying all the damage to the underlying economic activity across geographies in the wake of COVID 19 pandemic led lockdown.

We here, in this paper, are trying to infer the reason of this rally as Dow Jones is now less than 10 percentage points down from it’s all time high. Despite economists from every corner of the world are predicting a looming recession, the market has gone at a sheer divergence from underlying economics at the current levels.

We like to take a retrospective view to see the rationale behind this rally as there are so many unknowns to estimate anything for the near future as ever in the recent history. With no surprise, The Fed started acting on the rates and the monetary stimulus as soon as it could and broke the almost decade long dream of bond investors earning a positive real return which just started a few months back. The US 10-year treasury yield finally fell below 1%, first time ever in the history and touched a low of 0.31% in March. This was more than enough to turn everything at 180 degree for an investor. Let’ see the stats in the table below on 23rd March 2020 when the DJIA tested the low of 19173 at close

DateUS 10 Yr Bond Yield (BY)DJIA Trailing Earning Yield (EY)          EY/BY
23-Mar-20200.73%7.03%          9.57x

Based on the earnings of 2019, the earning yield of DJIA was 10 times more than the yield on US 10 Years Treasury Bond, so an investor was indifferent by buying DJIA instead of US treasury if it even takes roughly 9 years for the earnings to recover back to the level of 2019, of course it is pretty long time for things to get normal. However, this decade had been a decade of falling yield coupled with full employment across developed economies, this phenomenon had ensured equities in developed economies had a new normal of valuation. Let’s see how the things look like today

DateUS 10 Yr Bond Yield (BY)DJIA Trailing Earning Yield (EY)           EY/BY
05-June-20200.89%4.37%           4.91x
05-June-20192.12%5.61%           2.64x

As in the above table, there is still a decent gap between EY and BY today. We can expect the rates to remain at such levels for some more time given the inflation has fallen to 0.50% in April. But as economy is opening up and brent is back to $40, the inflation should rise and Fed will need to act to keep it to its target level of 2.00% where it was very much before the lockdown. How long will it take is an unknown but with a known variable – election year. Given such for the time being the above equation between equities and bonds may hold unless there is a reverse action by the Fed.

Coming back to domestic equities, India is just mirroring global markets during this rally, but we know the long term gsec rates here are already elevated to historically steepest spreads, the economy is already bewildered by credit and banking crisis, the equation between earning and bond yields is not similar to what that of the developed economies and the COVID pandemic is not looking to abate anytime soon here . We expect, Indian markets will follow their own path once the light of data comes in.

Clovek Research