Thoughts on the current economic environment and the impact of rising bond yields on equity performance.

1. Capital Preservation While Pursuing Superior, Risk-adjusted Returns
WilmotMLMacro Advisory ∙ Machine Learning ∙ Investments
Rising Bond Yields and Equity
Performance

2. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 2
We look at the performance of US equities since the early 1960s during all periods when
bond yields are rising
There were 16 distinct episodes before the current one, which began in July 2016
On 9 occasions real returns were positive: average return 21.7%
On 7 occasions real equity returns were negative: average return minus 7.5%
During 5 of those 7 episodes equities declined while earnings rose (multiple contraction)
while earnings growth was negative on two occasions –slide 10
Based on this sample there is a 56% chance of equities giving positive returns in a rising
rates environment
But that in itself isn’t very useful: equities usually begin by posting (strongly) positive
returns -11 out of the 16 rising yield episodes – slide 3
In 5 of those 11 episodes equities fell sharply in the later phase of the rising yield trend
On three other occasions equities suffered significant declines just after yields peaked
Overall, equities tend to fare worst when bond yields are rising in high inflation
environments
Equities tend to post strongly positive returns when yields are rising in low inflation
environments – see slide 4
Equities in Rising Yield Environments I

3. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 3
Real Equity vs Bond Returns During Episodes of Rising Yields
40
60
80
100
120
140
160
Index
Equity Returns Bond Returns

4. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 4
0%
2%
4%
6%
8%
10%
-30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
AverageInflation
Total Equity Returns
Real Equity Returns vs Average Inflation Poly. (Real Equity Returns vs Average Inflation)
The Relationship between Equity Returns and Inflation During Episodes of Rising Interest Rates
Higher inflation, negative equity returns
Lower inflation, positive equity returns

5. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 5
Equities are most likely to show negative returns when:
1. Inflation is high and rising (policy makers become hostile)
2. Real bond yields rise sharply (risk free component of discount rises)
3. Perceived risk of recession rises (equity risk premium component of discount rate rises)
4. Corporate profits decline (actual recession)
5. Other risks of large equity drawdown increases (overvaluation/crowded positioning)
The current episode of rising yields is not really associated with risks 1 to 4, Despite hitting 3%
this week, US 10-year yields are up only 127 basis points in real terms so far, well below the
average. Earnings are rising strongly and recession risk is low
But it does have an element of risk no 5: positioning and valuation
Both institutional and individual investors have late cycle allocations to equities
And according to our composite valuation indicator equities entered the secular
overvaluation zone last December…..
Equities in Rising Yield Environments II

6. Capital Preservation While Pursuing Superior, Risk-adjusted Returns
-4
-3
-2
-1
0
1
2
3
0
20
40
60
80
100
120
140
160
180
ValuationIndex
Index
Equity Returns
Overvaluation Zone
6
Valuation Indicator
Equity Returns During Episodes of Rising Interest Rates and relative valuation

7. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 7
Equities in Rising Yield Environments III
In valuation terms the current situation is quite similar to the mid-1960s and 2006/7
Furthermore, earnings were growing, inflation was low but rising and the Fed was steadily
tightening. In the mid 1960s but not the mid-2000s , real bond yields were also quite low
In the 1965/6 episode, real equity returns declined 17% (roughly equivalent to a decline
towards 2400 in The S&P500)
However, real equity returns rose by 30% over the following year once the Fed tightening
paused and bond yields peaked
Equities went on to set a secular bull market high about 45% above the correction trough
another year later - despite the fact that the Fed had resumed tightening and bond yields rose
further
On the second occasion (2006/7) real equity returns were slightly positive over the following
year or so, before entering a major bear market and recession
History never repeats itself exactly….
But taken overall the current situation seems to have more in common with the mid-1960s
than with the last stages of the US housing and credit bubble in 2006/7

8. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 8
Equity Returns in Equity Overvaluation Episodes
0
20
40
60
80
100
120
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200
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73
ReturnIndex
Months From Overvaluation Signal
1905 1928 1965 1997 2006 2017
= Recession Dates

9. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 9
Rate
Trough
Rate Peak
Starting
Yield
Starting
Inflation
Ending
Yield
Ending
Inflation
Average
Inflation
Real
Equity
Returns
Real Bond
Returns
Dec 1962 Nov 1966 3.9% 1.2% 5.1% 3.1% 1.9% 35.4% -3.0%
Feb 1967 Jan 1970 4.5% 3.1% 7.9% 4.8% 4.5% -6.1% -24.9%
Apr 1971 Aug 1971 5.6% 5.0% 6.9% 4.6% 3.7% -4.4% 1.51%
Nov 1971 Sep 1975 5.8% 3.8% 8.4% 6.8% 6.4% -24.1% -13.3%
Jan 1977 Mar 1980 6.8% 6.2% 12.8% 8.9% 7.3% -8.1% -36.8%
Jul 1980 Oct 1981 10.2% 9.2% 15.4% 7.9% 8.1% -5.4% -19.6%
Mar 1983 Jul 1984 10.3% 5.5% 13.9% 4.0% 4.5% -1.7% -5.7%
Sep 1986 Oct 1987 7.0% 3.3% 9.6% 3.5% 3.4% 7.6% -5.1%
Mar 1988 Mar 1989 8.1% 4.0% 9.3% 4.4% 4.4% 12.6% 1.2%
Nov 1989 May 1990 7.8% 3.7% 9.1% 4.0% 3.6% 1.8% -0.9%
Oct 1993 Nov 1994 5.4% 2.6% 7.9% 2.2% 2.0% -2.6% -13.6%
Jan 1996 Jun 1996 5.5% 2.0% 6.9% 1.9% 1.6% 4.9% -8.4%
Oct 1998 Jan 2000 4.3% 1.2% 6.6% 1.7% 1.5% 25.3% -9.1%
May 2003 Jun 2006 3.7% 1.5% 5.0% 2.3% 2.0% 44.1% 0.4%
Dec 2008 Mar 2010 2.7% 1.2% 3.9% 1.3% 1.5% 30.6% -12.8%
Jun 2012 Jan 2014 1.5% 1.8% 3.0% 1.4% 1.5% 32.9% -9.1%
Episodes of Rising Bond Yields
*Inflation = CORE PCE

10. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 10
Episodes of Rising Bond Yields
*Inflation = CORE PCE
Rate
Trough
Rate
Peak
Nominal Bond
Yield
Real Bond
Yield
Real Equity
Returns CAGR
Real Earnings
CAGR
Dec 1962 Nov 1966 +220bp -70bp 8.1% 8.9%
Feb 1967 Jan 1970 +440bp +170bp -2.1% -3.2%
Apr 1971 Aug 1971 +130bp +170bp -10.6% 2.3%
Nov 1971 Sep 1975 +260bp -40bp -6.8% 1.0%
Jan 1977 Mar 1980 +600bp +330bp -2.6% 3.7%
Jul 1980 Oct 1981 +520bp +650bp -4.2% -6.8%
Mar 1983 Jul 1984 +360bp +510bp -1.3% 17.7%
Sep 1986 Oct 1987 +260bp +240bp 6.9% 5.1%
Mar 1988 Mar 1989 +120bp +80bp 12.6% 11.4%
Nov 1989 May 1990 +130bp +100bp 3.6% -31.4%
Oct 1993 Nov 1994 +250bp +290bp -2.4% 11.7%
Jan 1996 Jun 1996 +140bp +150bp 12.7% 10.0%
Oct 1998 Jan 2000 +230bp +180bp 20.7% 22.8%
May 2003 Jun 2006 +130bp +50bp 12.5% 16.3%
Dec 2008 Mar 2010 +120bp +110bp 21.0% 125.1%
Jun 2012 Jan 2014 +150bp +190bp 18.2% 5.1%

11. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 11
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
YoY PCE (During Episodes of Rising Rates)
YoY PCE (During Episodes of Declining Rates)
10Y Bond Rates (During Episodes of Rising Rates)
10Y Bond Rates (During Episodes of Declining Rates)
PCE (YoY) VS 10Y Interest Rates

12. Capital Preservation While Pursuing Superior, Risk-adjusted Returns 12
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