Source: Wall Street

There is no negative correlation between the short-and medium-term volatility of long-term interest rates and equity valuation; the overall rise of the interest rate center and the decline of short-term inflation premium will affect the valuation, which may occur in the second half of 2021 with the withdrawal of Fed asset purchases.

Bank of China research believes that historical data show that there is no negative correlation between short-and medium-term fluctuations in long-term interest rates and equity market valuations.

In the short-term fluctuation, the negative correlation between real interest rate and valuation can be understood from "the relative growth rate of real interest rate is negatively correlated with valuation". The current rising inflation premium is supporting the valuation of US stocks.

Bank of China believes that future valuations of US stocks may be suppressed when interest rate centers rise as a whole and short-term inflation premiums fall..

This is likely to happen in the second half of 2021, when it is likely to be accompanied by the start of the Fed's asset purchase exit, which will have a significant negative impact on the market.

Real interest rates in the United States may be bottomed

Recently, under the influence of the Fed's proposal to reduce asset purchases + start using vaccines + Biden's $1.9 trillion fiscal spending proposal, US bond yields rose rapidly, with 10-year US Treasury rates hitting 115BP at one point, and TIPS rates and real interest rates also rebounded.

The Bank of China believes that as long as the rate of rise in nominal interest rates is relatively in line with inflation compensation, that is, real interest rates do not rise much, the real financing cost pressure on companies and the federal government will not rise too much (the profit recovery caused by higher inflation will offset the rising financing costs of nominal interest rates), so the Fed will not intervene in the rise of nominal interest rates.

However, if the recovery of US inflation data is not as expected, or if nominal interest rates rise significantly faster than inflation compensation, the Fed does not rule out the possibility that the Fed will adjust its bond purchase duration structure to suppress long-term interest rates.At present, although the real interest rate has bottomed out, it is unlikely to rise by a large margin in the short term.

There is no negative correlation between long-term interest rate and equity valuation in medium-and short-term volatility.

Bank of China Securities pointed out thatIn the long-term dimension, there is a certain negative correlation between long-end interest rate and equity market valuation.

In a variety of classical discount models, the long-end interest rate exists as the denominator, so intuitively there is a negative correlation between interest rate and stock price. In the CAPE (cyclically adjusted price-earnings ratio) data collected by Robert Shiller, we can see that the two historical lows of US stocks (1921 and 1981) basically correspond to the highs of long-end interest rates, and long-end interest rates in the United States have been falling since the 1980s, corresponding to the general upward trend of CAPE in US stocks. .

However, in the short-and medium-term fluctuations, there is no negative correlation between long-end interest rates and equity market valuations.

The monthly data of long-end interest rates and valuations over the past 20 years have two main characteristics:

(1) the real interest rate (here expressed by the difference between the 10-year US debt rate and the 10-year inflation swap rate) is basically the same as the nominal interest rate, except for the divergence between the two during the 2008 financial crisis. this was caused by the sharp decline in inflation premiums at that time (investors thought there was increased uncertainty about the downward inflation).

(2) if 2013 is taken as the dividing line, there is a positive correlation between long-end real interest rate / nominal interest rate and valuation before 2013, and the correlation coefficient is 0.67; from 2013 to 2020, there is no obvious correlation between real interest rate and valuation, and the correlation coefficient is-0.02.This is actually the same problem as the recent discussion on "whether the 60-40 stock bond allocation portfolio can continue to hedge risk", that is, before 2013, the financial market showed the phenomenon of "interest rates rise when stock prices rise, and interest rates fall when stock prices fall". Therefore, bonds can better hedge the risk of the equity market, and this correlation is disappearing in recent years.

The direct negative correlation between interest rates and stock prices / valuations is more central than short-term volatility.In the longer time dimension, it can be observed that higher interest rate centers tend to correspond to lower valuation centers, and vice versa. For example, the downward trend of long-end interest rates since the 1980s corresponds to the upward trend of CAPE, and the higher interest rate centers before the financial crisis (compared with those after the financial crisis) correspond to lower valuation centers. Short-term fluctuations in valuation levels may be more dominated by trading behavior, so you can see a positive correlation between valuations and bond yields.

At the same time, the relative growth rate of real interest rates and nominal interest rates seems to have some explanation for valuation fluctuations.It can be seen that although the explanation of inflation premium on the absolute value of US stock valuation is weak, the short-term fluctuations of the two are basically the same. Because the inflation premium is equal to the nominal interest rate minus the real interest rate and then the inflation expectation, in the model, the long-term inflation expectation is relatively stable, in this case, the inflation premium can be regarded as the relative growth rate between the nominal interest rate and the real interest rate. When the inflation premium rises, it shows that the nominal interest rate rises faster than the real interest rate, and when the inflation premium decreases, the nominal interest rate goes down faster than the real interest rate.

The relative growth rate of real interest rate is negatively related to valuation.

The Bank of China saidIn the short-term fluctuation, the negative correlation between real interest rate and valuation can be understood from "the relative growth rate of real interest rate is negatively correlated with valuation".

When long-term inflation expectations are relatively stable, the change of nominal interest rate can be roughly divided into inflation premium and real interest rate. Inflation premium is usually related to corporate profitability, while real interest rate can be regarded as "real cost of capital".When the inflation premium rises, it can be seen as a rise in the "profit expectation" portion of the company's nominal cost of capital, so investors are willing to pay higher valuations, and the current rising inflation premium is supporting US stock valuations.

Rising inflation supports US stock valuations

The Bank of China believes that the direct cause of persistently low inflation in the United States after the 2008 financial crisis is the cyclical dislocation of durable goods and non-durable goods prices, which is caused by the dislocation of durable goods prices and oil prices. The impact of the epidemic has resynchronized the price cycle of spending on durable goods, non-durable goods and services, eliminating the direct cause of persistently low inflation in the United States over the past decade.

With vaccines widely used in the first half of 2021, both supply and demand in the United States will recover, higher core inflation will occur, and both durable and non-durable goods are expected to enter the inventory replenishment phase in the second half of 2021. At the same time, as the epidemic has not caused too much medium-and long-term damage to economic fundamentals and stimulated by extremely loose fiscal and monetary policies in Europe and the United States, this cycle of recovery will be more violent than after the financial crisis.

Under the strong expectation of recovery, the current oil price has taken the lead in rebounding, while durable goods inflation has finally returned to the positive range under the triple influence of the rapid recovery of new durable goods orders, low interest rate environment and financial subsidies, and the upward momentum continues unabated.

Bank of China believes that a rebound in US core inflation is imminent (the year-on-year growth rate of core PCE has rebounded in December), which has also been expected in the near future, and high valuations of US stocks are expected to be supported.

The risk of US stocks in re-inflation

BOC said that current US stock valuations may be suppressed in two cases: (1) when the interest rate hub rises as a whole (for example, when the 10-year Treasury interest rate center rises to 2.5-3.0%); and (2) the decline in inflation premium in the short term.

In terms of the overall rise of the interest rate centerThe Bank of China said the rise in the interest rate hub would not be seen until after the Fed raised interest rates for the first time.In 2021, the Fed is expected to maintain its policy focus in the face of high core inflation, and it is unlikely to raise interest rates; but the long-term core PCE growth rate above 2.5% after 2022 will put pressure on the Fed's monetary policy. In order to avoid excessive upward inflation expectations, the Fed may raise interest rates in 2022.

With regard to the decline in inflation premium in the short term, the Bank of China believes that the decline in inflation premium may occur in two scenarios.The first situation is that the actual inflation figures are lower than expected.The trigger may be a weaker-than-expected recovery as a result of the higher-than-expected development of the epidemic, or an unexpected collapse in energy prices, but this condition is generally not the benchmark for our study.

The second situation is when inflation expectations start to rise.This usually occurs after a period of re-inflation, when investors raise their inflation expectations, but the change in inflation compensation lags behind, making the inflation premium lower, thus compressing valuations (see the case of 2015-2016H1).The Bank of China expects this to happen in the second half of the year, when it is likely to be accompanied by the start of the Fed's asset purchase exit.