What do low Treasury yields tell us about expected stock returns?
by Dr. Brian Jacobsen, CFA, CFP, Wells Fargo Asset Management
I’m often guilty of burying the lede, so I’ll cut to the chase: What do low Treasury yields tell us about expected stock returns? Not much. It all hinges on why Treasury yields are low and whether they’re going to stay low. Things change quickly in this world, so I don’t like making long-term forecasts. But I can tell you that a variety of factors can contribute to low Treasury yields:
- When they get pushed lower due to expectations of ample central bank support, it tends to be good for risk assets.
- When they get pushed lower due to expectations of low growth, or a surge in fear, it tends to be bad for equities.
- Today, Treasury yields probably are low for a mix of those reasons.
That’s what can keep the equity markets on tenterhooks: to see whether fear gives way to growth. So far, I think the data is showing a low risk of recession, so I remain bullish, albeit a skittish bull, and data-dependent, like the Federal Reserve (Fed).
Treasury yields have been lower in the past than they are today—not in nominal terms, but in inflation-adjusted terms. I looked at the monthly data on 10-year Treasury securities going back to 1876 from Global Financial Data and adjusted the nominal yields for the subsequent 10-year annualized inflation to get realized real yields. Ideally, I would have used expected inflation instead of realized inflation, but there is no good data source on what people of 1920, for example, were expecting inflation to be (if you know of a good source, let me know).
It’s reasonable to assume that over the next 10 years, inflation will average 2% in the U.S. That’s the Fed’s target and I think it’ll hit that target—eventually. On that basis, a 10-year Treasury that yields 1.40% has an expected real yield of -0.59%. Maybe people expect inflation to be lower than 1.4%, which could justify a sub-2% yield, but that’s unlikely; if there’s a Fed balance sheet, there’s a way to get inflation.
There were three previous time periods in which the real 10-year yield was negative: 1907 to 1917, 1935 to 1947, and 1964 to 1974. As the following chart shows, the S&P 500 Index’s total return (10-year inflation adjusted annualized) was negative in the 1907–1917 period and in the 1964–1974 period. However, the return was very positive during the 1935–1947 period.
What’s the difference between when the S&P 500 Index’s returns were positive versus negative? The answer is growth, not valuations, and not the starting level of yields. It was simply whether the economy began growing despite the low yields.
The average real return on the S&P 500 Index (including dividends) was 6%. There is a loose relationship between real Treasury yields and real stock returns. Only 14% of the variation in stock returns is explained by variation in real Treasury yields. In other words, 86% of returns are determined by other factors. A negative real Treasury yield of 0.59% corresponds to about a 4.4% real stock return (annualized over 10 years). What really helps is to know whether real growth is picking up or slowing. If it’s slowing, the projected 10-year annualized total return on the S&P 500 Index is 1.9%. If it’s picking up, then it’s 9%.
So, take your pick: If you’re a bear on growth, then you can reasonably expect around 2% total return on stocks per annum over the next 10 years. If you’re a bull on growth, then 6% to 9% is feasible. Since the dividend yield on the S&P 500 Index is approximately 2.27%, I can understand why people—bull or bear—are bidding up the price of dividend-paying stocks. A bird in the hand is worth two in the bush—although considering ticks and bugs, I’d rather look at a bird from a distance than hold one. For a bear, dividends could make up 100% of your expected return. For bulls, it could make up a third to a fifth of your total return.
Regardless of bull or bear, I think you can do better than Treasuries. There’s more to the investment universe than Treasuries and the S&P 500 Index. Within the fixed-income universe, for example, 45% of U.S. investment-grade debt (labeled as U.S. aggregate in the below chart) yields more than 2%. Nearly 100% of U.S. high-yield debt yields more than 2%. So, don’t fixate on or fret over low Treasury yields. You can do better.
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