Goldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period. The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.
Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years. If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds. If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.
This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.
Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier. From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.
Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years. Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards. If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.
Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation. During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy. The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.
What Has to Happen for Goldman’s Outlook to Play Out?
To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth. In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation. This has been the prevailing state of the U.S. economy over the last fifty years. Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s. If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.
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