Equity risk-reward may turn favourable as bond-earnings yields spread narrows

NEW DELHI: Equities might have become very risky in the countdown to US Presidential election on Tuesday, but the recent rebound in earnings and narrowing spread between bond and earning yields suggests that the risk-reward ratio is likely to turn favourable for equities in the medium term.

At present, 10-year sovereign bond yield stands at 6.8 per cent and the one-year forward earnings of the Nifty50 is pegged at 6.1 per cent; which results in a bond-equity earnings yield ratio or BEER ratio of 1.11. A BEER value above 1 suggests that stocks are overvalued and that the risk-reward is unfavourable.

Earnings yield is the inverse of PE ratio (i.e. EPS/Share price).

However, brokerage ICICI Securities believes the earnings yield is set to get more attractive to bond yield “in the event of (a) temporary volatility in stocks due to adverse US election outcome; and (b) inflation marginally undershooting the RBI target by March 2017, which is a high probability.”



While the performance of the equity market has been overshadowed by the recent volatility in the US markets, the spread between India’s 10-year bond yield and the Nifty50’s earnings yield based on one-year forward estimates has reached its lowest level since the emerging market (EM) selloff in 2013, ICICI Securities said.


"The current situation is a function of improving fundamentals – (a) 10 year bond yield cools off as CPI dips on a sharp correction in food prices due to adequate monsoons and better management of food prices by the government; (b) the government's pro-reforms agenda; (c) continued decline of the twin deficits; (d) adequate forex reserves: and (e) stable rupee. Moreover, earnings yield is on a firmer footing given the significant downgrade cycle (in the past 18 months, FY18 EPS got downgraded by per cent 26 per cent), recovery in earnings growth in past three quarters and conservative consensus estimates," the brokerage said.

The brokerage said any adverse outcome from the US election may result in a sharp global equity selloff. In such a case, the US Fed may not hike interest rate anytime soon, which may somehow stabilise the situation.

On the other hand, even if the US election outcome is favourable and the Fed initiates its rate hike cycle, it would be a long-drawn process and is unlikely to create upheavals in global capital markets.