EFTA01464570.pdf

Deutsche Bank Markets Research North America United States Periodical US Equity Insights 3 reasons not to fear a 3%+ 10yr yield 1600 should be good support even if 10yr treasury yields go a little over 3% As discussed last week, we are increasingly tolerant of higher treasury yields given the coincident climb in the euro and oil prices. Treasury yield normalization poses little threat to S&P EPS provided euro and oil prices prove resilient. Our view that the chief risk to EPS from higher yields is via FX and commodity prices is sometimes challenged by investors who see other threats to EPS from higher interest rates, such as interest expense, or threats to the S&P's valuation. This note gives a few reasons to discount these concerns. Interest expense is relatively small and likely overpowered by pension swings Net interest expense at S&P 500 non-financials is likely under $150bn in 2013, which after-tax is roughly $10 of EPS. Essentially all of the $2trn in net debt at non-financials is now long-term debt because cash is more than double shortterm debt and companies have been using more long-term debt in their debt mix. Usually 10-15% of long-term debt rolls over each year and much of it is still rolling to lower rates. But, if we assume that 15% of long-term debt rolls to a rate 100bp higher the hit to 2014 S&P EPS would be —$0.25. If we assume that the effective interest rate rises 200bp on all non-financial net debt the hit to S&P EPS is about $3, but if this occurs it would play out over several years. Pension expense at S&P non-financials is likely to fall more than an increase in borrowing costs as long-term yields rise, particularly through 2015. The improved pension funding we expect at 2013 end should provide a —$2 benefit to S&P EPS in 2014. If yields rise another 100bp at 2014 end it would eliminate deficits and provide another —$2 S&P EPS boost in 2015 (not in our estimates). Pension expense declines would likely stop at this point even if yields climbed higher because of likely shifts in pension asset allocations. This would cause some pension drag from lower ROA assumptions, but all considered lower pension expense should offset higher long-term borrowing rates. Financial earnings will likely benefit from higher treasury yields and eventually EFTA01464570 higher short-term interest rates. Thus, we see little threat to overall S&P EPS. A -15 forward PE wouldn't be threatened until 10yr yields were well over 4% Assuming a fair S&P 500 equity risk premium of 4% (historically 3-4%), it would likely require a 10yr treasury yield of -5% or a 10yr TIPS yield over 2% to threaten the fairness of a —15 forward PE on normalized S&P EPS. However, such an increase in long-term interest rates would significantly amplify US fiscal risk. Thus, it is important that any such climb in yields be slow and over multiple years, while the deficit is further tamed and housing strengthened. Treasury yields now exceed the dividend yield, but won't grow like dividends Dividend yields like earnings yields represent real yields. Expected inflation must be added to these observed yields in order to compare them to nominal interest rates. The 10yr TIPS yield provides a comparable real interest rate, which at 0.75% suggests that EPS and DPS yields remain very attractive. The S&P's indicated dividend yield is 2.1% and we expect DPS growth to be —15% next year and at least 6% thereafter. This suggests an offered long-term nominal return on S&P ownership over 8% with the ability of that offered nominal return to adjust for inflation variations over the long term. Date 23 August 2013 David Bianco Strategist Ju Wang it S&P 500 Key Forecasts Price 1660 Next 5%+ move Uncertain 2013E Year-end Target EPS Target P/E Current P/E DPS Priya Hariani Strategist 1675 1850 2000 $109 $115 $120 15.4x 16.1x 16.7x 15.2x 14.4x 13.8x $36 EFTA01464571 $40 Source: Deutsche Bank Related recent research Good signals from yields, euro and oil S&P 500 Pensions: End of cycles? $45 Date 16 Aug 2013 31 Jul 2013 Multi-year path to PE expansion 14 Jun 2013 How do interest rates affect stocks? 31 May 2013 Source: Deutsche Bank US Equity Strategy Baskets Tech's Enduring Eight Total Shareholder Return Stimulator Dividend Dark Horses China Cyclicals Source: Deutsche Bank Bloomberg Ticker DBUSTECH DBUSBBD1 DBUSDFCF DBUSCNCY Deutsche Bank Securities Inc. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013. EFTA01464572 23 August 2013 US Equity Insights 3 reasons not to fear a 3%+ 10yr yield Interest expense is relatively small and likely overpowered by pension swings Figure 1: S&P ex-financials net debt/market cap at 14% is considerably lower than historical levels 0% 10% 20% 30% 40% 50% 60% 70% 0% 10% 20% 30% 40% 50% 60% 70% EPS hit from higher interest rates is likely to be very small and should be overpowered by pension swings. If we assume that 15% of the $2.8 trillion in long-term debt rolls to a rate 100bp higher the hit to 2014 S&P EPS would be —$0.25. Pension expense is likely to fall by more and a 100bps increase in long-term rates should eliminate pension deficits. Recession Source: Deutsche Bank Net Debt / Market Cap Figure 2: Share of long-term debt (>1y)at S&P ex. financials has increased to 85% from 75% in 2003 Figure 3: S&P ex-financial cash, current and long-term debt ($ millions) 60% 65% 70% 75% 80% 85% 90% Recession EFTA01464573 Source: Deutsche Bank Long-term debt/ Total debt 60% 65% 70% 75% 80% 85% 90% 1,000 1,500 2,000 2,500 3,000 500 0 Current Debt Source: Deutsche Bank 500 1,000 1,500 2,000 2,500 3,000 0 Long Term Debt Cash Figure 4: S&P ex-financial interest expense/sales at 1.5% is the lowest level since 1970 100,000 120,000 140,000 160,000 40,000 60,000 80,000 Interest Expense -LTM ($bn, lhs) Interest Expense/Sales (rhs) Source: Deutsche Bank 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% Figure 5: 10-15 year IG corporate bond yield is up 100bp from 1Q13 end but still below 2011 end. 10.0 0.0 2.0 EFTA01464574 4.0 6.0 8.0 IG (10-15 years) Corporate Source: Bank of America Merrill Lynch, Deutsche Bank 10 yr Treasury 0.0 2.0 4.0 6.0 8.0 10.0 Page 2 Deutsche Bank Securities Inc. 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 EFTA01464575 2009 2011 2013 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 EFTA01464576 2007 2009 2011 2013 EFTA01464577 23 August 2013 US Equity Insights Figure 6: S&P 500 trailing PE and implied equity risk premium: PE is now close to long-term historical average but ERP is still 200bps higher than its average of 390bps. 10 15 20 25 30 35 0 5 LTM PE (lhs) Source: S&P, FRB, Deutsche Bank Implied ERP (rhs) Avg PE = 15.9 Overstated EPS from inflation distortions 0% 2% 4% 6% 8% 10% 12% A -15 forward PE wouldn't be threatened until 10yr yields are well over 4% or 10yr TIPS exceed 2%. Treasury yields now exceed the dividend yield, but dividends should grow double-digit for the next few years as the payout ratio rises from 33% now. Dividend yields like earnings yields represent real yields. Expected inflation must be added to these observed yields in order to compare them to nominal interest rates. The 10yr TIPS yield provides a comparable real interest rate, which at 0.75% suggests that EPS and DPS yields remain very attractive. The S&P's indicated dividend yield is 2.1% and we expect long-term DPS growth to be —15% next year with at least 6% growth thereafter. This suggests an offered long-term nominal return on S&P ownership over 8% with the ability of that offered nominal return to adjust for inflation variations over the long term. Figure 7: S&P Dividend yield, 10yr Tsy and TIPS yield -2% 0% 2% 4% 6% 8% 10% 12% EFTA01464578 14% 16% S&P Dividend Yield 10yr TIPS yield Source: S&P, FRB, Deutsche Bank 10% 12% 14% 16% -2% 0% 2% 4% 6% 8% 10yr Treasury Yield Figure 8: S&P 500 dividend growth (y/y % chg) -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% Recession Trailing 4-qtr DPS growth (y/y % chg) Source: S&P, Deutsche Bank Deutsche Bank Securities Inc. Page 3 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 1960 1964 1968 1972 EFTA01464579 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 EFTA01464580 23 August 2013 US Equity Insights Appendix 1 Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. David Bianco/Priya Hariani/Ju Wang Equity rating key Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ) , we recommend that investors buy the stock. Sell: Based on a current 12-month view of total shareholder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Notes: 1. Newly issued research recommendations and target prices always supersede previously published research. 2. Ratings definitions prior to 27 January, 2007 were: Buy: Expected total return (including dividends) of 10% or more over a 12-month period Hold: Expected total dividends) between -10% and 10% over a 12month period Sell: Expected total return (including dividends) of -10% or worse over a 12-month period return (including Equity rating dispersion and banking relationships 100 200 300 400 500 600 0 Buy Companies Covered EFTA01464581 Hold Sell Cos. w/ Banking Relationship North American Universe 46 % 55 % 52 % 46 % 2 %35 % Page 4 Deutsche Bank Securities Inc. EFTA01464582 23 August 2013 US Equity Insights Regulatory Disclosures 1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. 2. Short-Term Trade Ideas Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com. 3. Country-Specific Disclosures Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. 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