The Duration Risk in Equities

Since early 2017 there has been a notable gap between the expected growth in future dividends and the performance of the US equity market. The value of the 10 S&P 500® annual dividend index futures contracts at the end of April were eqivalent to about 500 S&P 500® index points, to be paid between now and the end of 2030. Remarkably, that's less that what was priced in 2017. Yet, despite the recent COVID-19-induced bear market, the S&P 500® index has risen from 2,250 to 2,900 points since 2017 (Figure 1). Before the pandemic, expected dividend growth was stagnant even as equities soared.

So why did the equity market rally even as expected dividends were stagnating (and falling, more recently)? The answer appears to be that long-term interest rates have been falling since Q4 2018. Between the end of September 2018 and the end of April 2020, 10-year US Treasury yields fell from 3.21% to 0.58%. What's more is that while the forward dividend yield of the S&P 500® as implied from annual dividend index futures has declined over the same period, it hasn't fallen nearly as much, going from 2.5% to 1.85% (Figure 2). Even as many corporations have slashed dividends in response to the economic impact of the pandemic, the US equity market as a whole now yields far more than government bonds. Even the US 30-year Treasury yields only 1.2% -- less than one third of what it was 18 months ago.

Lower long-term interest rates have increased the net present value (NPV) of future dividend payments. If one takes the same data in figure 1 but discounts the next 10 years of dividend payments into present value using swap rates, one finds that the S&P 500® and the NPV of future dividends have moved in lockstep (Figure 3). What this implies is that future equity returns are dependent on two factors: 1. Changes in expected future corporate cash flows 2. The level of long-term interest rates

If long-term interest rates remain low or fall further, all else being equal, that would likely be bullish for equity markets. By contrast, if long-term bond yields were to suddenly rise, that would likely detract from equities' performance. Indeed, if one measures the S&P 500® market cap as a percentage of GDP over long periods of time, it tends to vary inversely with the level of long-term bond yields (Figure 4). Currently, the equity market still has a historically high market cap/GDP ratio of 121% at the end of April, suggesting that stocks are not cheap except when priced relative to bonds.

So far, both US Treasuries and US equities have rallied in the face of much larger US budget deficits. In the past 12 months, the federal budget deficit was 5% of GDP. In the coming 12 months it could be in the 20-25% range or possibly higher if more relief/stimulus legislation is passed. The US government debt-to-GDP ratio could rise from 104% at the end of 2019 to 130% or higher by the end of 2020. Even so, as we have seen in our longitudinal (see our article here) and cross-sectional studies (see our article here) of debt levels and interest rates, higher levels of indebtedness typically translated into lower, rather than higher, bond yield levels. As such, much larger US budget deficits won't necessarily push long-term bond yields higher in the near term, to the likely benefit of equity investors. Even so, over the longer term, the modern monetary theory-like (see our paper here) fusion of US monetary and fiscal policy that has taken place in the past few months could eventually spur inflation and lead to a rise in long-term bond yields. Increased protectionism and localization of production also represent long-term inflation risks. If that happens, perhaps later in the 2020s, it could create a challenging environment for the equity market. The rising yield environment from 1965 to 1980 saw the S&P 500® market cap plunge from around 110% of GDP to as little as 30%. In nominal terms, equities went nowhere from 1966 to 1982, while they fell by 70% in inflation-adjusted terms. So, for the moment, the equity market seems to be driven by two forces: changing expectations for economic growth, exemplified by the pricing of annual divided index futures (Figure 5) and movements in long-term bond yields. With immense deflationary pressure stemming from the decline in energy prices and the dislocation in the labor market, inflation seems like a distant threat. That said, long-term bond investors aren't the only ones who should be concerned about duration risk, it seems.