What does a low yield mean?
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THE French economy is not exactly in the rudest of health and confidence in the government of Francois Hollande (who just reshaped the cabinet to get rid of the economy minister) is not high. But investors are willing to pay money to own French two-year bonds, in the sense that they now (along with five other euro zone countries) have a negative yield. Yields are also very low at the ten-year level, with both German and Swiss bonds offering less than 1%. But it is not just bonds that offer a low yield; US equities have a dividend yield of just 2.3% and residential property in many markets offers a much lower yield than average (see chart).
So what does a low yield mean? We should distinguish, of course, between nominal and real yields. Japanese yields were very low in nominal terms for a long time but were still significant in real terms, thanks to deflation. With European inflation at 0.3% (and falling), then a German ten-year yield of 0.9% might seem reasonable, if one expects the low inflation to persist. Conventional bonds are fixed in value, and thus a low nominal yield normally indicates that investors expect inflation to be low or negative.
The existence of index-linked bonds gives us some idea of investors' long-term expectations for inflation, by comparing the yield on these instruments with those on conventional bonds of the same maturity. These are around 2% for the US and 3% for Britain, although the numbers may be distorted by the high demand for index-linked bonds from pension funds, for whom such bonds are a natural hedge. Real yields on quite long-dated UK index-linked bonds are negative.
When it comes to equities, a low yield may tell a different story. For individual stocks, a low yield is usually the sign of a growth stock while a higher-than-average yield is a sign of a mature business that is generating lots of cash. Since the fair value of a stock is the discounted value of future cashflows, a low yield can be seen as a sign either that dividend growth is likely to be rapid or that the investor expects most of the return to come from capital gains (although in the long run, these amount to the same thing).*
Is property more like equities or bonds? Certainly, the appeal of property to many investors comes from the steady income. One argument why UK property prices are high is that interest
rates are low. This lowers the cost of servicing debt for homeowners and so makes property relatively more attractive for landlords (buy-to-letters in the jargon). But many people buy property for the expected capital gains. A lower-than-average initial yield must imply faster rental growth in future, as with a tech stock.
It is at this point that it is hard to make market valuations stack up. Bond yields are low because inflation expectations are low. So that should mean that nominal income growth is low. But if that is the case, how are renters going to be able to afford to pay the higher future rents implied in British property prices?
You might say that bond yields are low because they have been manipulated by central banks. But central banks have taken these actions because they are worried about economic growth (and they have been right so far; Britain has only just regained its pre-crisis GDP). If they are right, then equity investors should worry as well. US corporate profits are already close to a post-1945 high relative to GDP. How much further can they rise in a slow-growing world? The usual answers to this query are twofold. One is that capital has gained at the expense of labour (and will keep doing so); a "this time is different" argument. The second is that the equity yield is higher than it appears to be, because of buy-backs. But share buy-backs fell 20 per cent in the second quater in the US and were lower than they were in Q2 2013. And executives are terrible market-timers; buying when prices are high. They spent 40% of their cashflow on buy-backs in the first quarter of 2008, just before the Bear Stearns rescue and just 20% of their casfhow in early 2009 when the market bottomed.
The most rational answer is that low yields imply low future returns, for equities and property as well as bonds. Ray Dalio of the Bridgwater hedge fund reckons the likely future real returns from a stock/bond portfolio may be barely positive. But this only leads to another paradox; those investors who are buying equities and property can't really be expecting such returns, can they?
* Yes, some stocks pay no dividend at all. But unless all investors are buying on the "greater fool" theory, the assumption is surely that the value of the overall business will eventually be realised, perhaps via a takeover, with the predator eager to capture the cashflows from the business.
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