-        Will rising corporate bond yields put pressure on US equities?

-        Fed is still likely to raise rates before the Bank of England

-        Yellen will probably be approved as nominee for the Fed Chair (15.00 GMT)

 

Key Market Themes

The earnings yield of a stock market index should be closely related to the average real yield of long-dated bonds issued by its constituents. In the US, we think the latter is likely to rise significantly during our forecast window. However, the gap between the earnings yield and the average real bond yield is currently more positive than usual. So the downside for equity prices might be limited. (See our Global Markets Update, “Will rising corporate bond yields put pressure on US equities?”, published on Wednesday.)

 

The earnings yield (the reciprocal of the price/earnings ratio) and the rate at which investors discount corporate earnings are linked.  In fact, when the stock market is in equilibrium, the two will be identical. Accordingly, if the discount rate rises, stock prices will tend to fall.

 

The yield on long-term conventional Treasuries is often selected as a proxy for the rate at which corporate earnings is discounted, since the latter is not directly observable. But this is an inappropriate choice for two reasons. First, equities are real assets, whereas conventional Treasuries are not. Second, equities are “risky”, whereas Treasuries are widely considered to be effectively “risk-free”. It therefore makes more sense to compare the earnings yield to an average real corporate bond yield.

 

Chart 1 on page 1 shows the gap between the 10-year cyclically-adjusted earnings yield of the S&P 500 and our estimate of the real yield on corporate bonds since 1960. The good news for stock market bulls is that, at around 0.9%, the gap today is significantly larger than its more-than-half-century average of minus 0.3%. This suggests there is scope for it to close without putting upward pressure on the earnings yield.

 

The bad news is that the gap has already shrunk substantially from this time last year, when it was as at its largest since the late 1970s. What’s more, we think the gap will have to plunge well into negative territory if the earnings yield itself is not to climb. This is because we forecast the real yield on corporate bonds to rise by nearly 2% by the end of 2015 as the Fed gradually becomes less accommodative.

 

Admittedly, the gap has been even more negative than minus 0.9% in the past, most notably during the stock market bubble of the late 1990s. But this is no cause for comfort. At the least, we think upward pressure on real corporate bond yields is set to undermine the valuation case for equities over the next few years. (John Higgins)

 

What to watch for today: US

The underlying monthly trade deficit (13.30 GMT) has remained broadly unchanged over the past few years and we suspect that there was little change in September. Including petroleum-related trade, we think the monthly deficit was $38.5bn, down from $38.8bn in August. Otherwise, the survey evidence points to a pick-up in the growth of both non-energy exports and imports. (Paul Ashworth)

 

We do not expect that Janet Yellen will have any problem in securing approval as nominee for the Fed Chair in her appearance in front of the Senate Banking Committee (15.00 GMT). If so, her nomination would then proceed to a full vote in the Senate sometime in the next few weeks. In her testimony, Yellen is unlikely to provide any hints of whether she favours tapering the Fed’s asset purchases sooner or later. Instead, she will probably stick very closely to the Fed’s script that the timing of tapering will be determined by the data. But we will still be looking closely for any departures from the party line. (Paul Dales)

 

Canada

International merchandise trade (13.30 GMT) data, which were postponed because of the US government shutdown, are likely to show that the merchandise trade deficit was largely unchanged in September, at close to C$1.3bn. (David Madani)

 

Continental Europe

The provisional euro-zone GDP release for Q3 (10.00 GMT) is likely to show that the economy expanded on the quarter, but only by 0.1%. Although euro-zone level survey indicators such as the composite PMI index improved further in Q3, on past form they point to only a small quarterly rise in GDP of between 0.1% and 0.2%, a touch weaker than Q2’s 0.3% gain. The hard data also support the view that GDP expanded by a bit less than in Q2. The bigger-than-expected monthly fall in euro-zone industrial production of 0.5% in September (data published on Wednesday), meant that production declined by 0.2% over Q3 as a whole, far weaker than the 1.0% expansion seen in Q2. On its own, this would be enough to shave 0.2 percentage points off GDP growth relative to Q2’s outturn.

 

The slowdown in the euro-zone as a whole is likely to have largely reflected developments in Germany (07.00 GMT) and France (06.30 GMT). We expect GDP in the former to have risen by 0.4% in Q3, after Q2’s healthy gain of 0.7%. Meanwhile, we expect a fall of 0.2% in France’s GDP last quarter, after a 0.5% quarterly rise in Q2. We expect GDP in Italy (09.00 GMT) and the Netherlands (08.30 GMT) to have contracted by 0.2% and 0.1% respectively on a quarterly basis. (Ben May)

 

UK

We expect the official measure of retail sales volumes (09.30 GMT) to have grown at a fairly subdued monthly rate of 0.2% in October. This unspectacular rate of expansion would be consistent with survey evidence for October, which pointed to a modest outturn for sales. However, this would still leave the annual growth rate at 3.3%, the strongest annual performance since September 2007. (Martin Beck)

 

As widely expected, the key development in the Inflation Report (published on Wednesday) was the downward revision to the MPC’s forecasts for the unemployment rate – the most important economic variable for monetary policy since the introduction of forward guidance back in August. This followed a fall in the unemployment rate from 7.7% to 7.6% in September (data also published on Wednesday). Against this background, Governor Carney went out of his way to stress again that the 7% threshold is merely a “way station” at which the MPC will re-assess the stance of monetary policy and not an automatic trigger for a rate hike. Given all of this, we remain of the view that interest rates will stay on hold rather longer than the markets expect as the effects of the large amount of spare capacity in the economy keep inflation low. (Jonathan Loynes)

 

Japan

The first estimate of Q3 GDP (23.50 GMT Wednesday) is likely to show a slowdown in quarterly growth to around 0.5% (2.0% annualised), after the 0.9% (3.8%) gain in Q2. Meanwhile, despite the 2.1% m/m fall in September, the upward trend in core machinery orders remains intact. This bodes well for a continued recovery in business capital spending, although this may not be enough to offset a drop back in housebuilding after the consumption tax hike next year. (Marcel Thieliant)

 

China

No major data or events scheduled for today.

 

Other Asia-Pacific

Since cutting interest rates in May, the Bank of Korea (BoK) has left monetary policy on hold and we do not expect it to make any change on Thursday (01.00 GMT). There is little need for the BoK to provide further support, given that recent GDP and manufacturing PMI data indicate the economy is showing signs of improvement. Meanwhile, inflationary pressures are very weak. Looking ahead, tepid wage and money supply growth should help to keep inflation within the BoK’s comfort zone. Overall, we think the policy rate will be kept at 2.5% until 2015. (Gareth Leather)

 

Latin America

No major data or events scheduled for today.

 

Emerging Europe

We think preliminary third quarter GDP data for Central and South Eastern Europe will confirm that the recovery in the region is on a firmer footing. Poland (09.00 GMT) appears to have been the star performer, probably growing by around 2.3% y/y, up from 0.8% y/y in Q2. Elsewhere, Romania’s economy may also have expanded by over 2% y/y, while growth appears to have picked up in Hungary and the Czech Republic (all at 08.00 GMT). The recovery has been supported by the recent improvement of key euro-zone export markets, notably Germany, but domestic demand has strengthened too. (William Jackson)

 

Key Data and Events

Wed 13th                 23.50    Jpn    GDP (Q3, Prov.)                           

                               23.50    Jpn    Consumer Spending (Q3, Prov.)                    

                               23.50    Jpn    Business Spending (Q3, Prov.)                       

                               23.50    Jpn    GDP Deflator (Q3, Prov.)                                         

Thu 14th                   01.00    Kor    Interest Rate Announcement

                               06.30    Fra     GDP (Q3, Prov.)

                               07.00    Ger    GDP (Q3, Prov.)

                               08.00    Hun    GDP (Q3, Prov.)

                               08.00    Cze    GDP (Q3)

                               08.00    Rom   GDP (Q3)

                               08.30    NE     GDP (Q3, Prov.)

                               09.00    Ita      GDP (Q3, Prov.)

                               09.00    Pol     GDP (Q3, Prov.)

                               09.30    UK     Retail Sales (Oct)

                               10.00    EZ     GDP (Q3, Prov.)

                               13.30    US     Initial Jobless Claims (9th Nov)

                               13.30    US     International Trade (Sep)

                               13.30    US     Non-Farm Productivity (Q3, Prov.)

                               13.30    US     Unit Labour Costs (Q3, Prov.)

                               13.30    CA     International Merchandise Trade (Sep)

                               15.00    US     Fed Nominee Yellen’s Confirmation Hearing

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