June 18, 2019—There are two sides to every story. And then there is the truth, which often lies somewhere in the middle. This is true of stock and bond markets today, and while we are not in the business of “taking sides,” we think there is truth to both narratives.
The bond side of the story
After confirmation from European Central Bank president Mario Draghi that further easing would be on the way in the absence of growth and inflation improvement, French 10-year government bond yields hit 0% for the first time ever, and the 10-year German bund yield is making fresh all-time lows at -0.32% (Figure 1). In the U.S., the 10-year U.S. Treasury is flirting with a yield below 2%, the lowest since 2016. Market-based expectations of the average inflation rate five years from now are below 1.8%, also the lowest since 2016. The fed funds futures market is pricing in at least three rate cuts from the Fed over the next twelve months. The yield curve has been inverted (between the 10-year and 3-month tenors) for almost a month.
Figure 1: Pessimism in Rate Markets
As of June 18, 2019. Source: Bloomberg.
This does not paint a positive picture. In fact, interest rate markets seem to be providing a pretty stern warning that global growth is on the precipice of a recession. However, credit and equity markets are telling a different story.
The risk markets’ version
Credit markets, focusing on high yield in particular, have seen interest rate spreads rise over the past few months, to around 4% from 3.5% in April. This is neither significant nor worrisome, as it compares to an option-adjusted spread of 5.4% in December 2018 and 8.4% in January 2016. In addition, this increase in spreads is a result of the overall collapse in Treasury yields, not an elevation of default risk. In terms of equity markets, after a very sharp correction in December 2018, global equities are up almost 14% year to date. The S&P 500 is hanging in there with a total return of over 16%, less than 2% off all-time highs. Though defensive sectors have generally outperformed over the last three months, technology and consumer discretionary (which do better in a risk-on, pro-cyclical market) are still two of the three best-performing sectors in the S&P 500 year to date. The price-to-earnings ratio on the S&P 500 of 16.5x next-twelve-month-earnings is 10% above its 10-year average.
Did the equity market not get the memo? Or is the bond market too pessimistic?
In our view the proper tone to strike is somewhere in the middle of both of these markets. The chance of a policy misstep related to trade is high, and we believe further escalation of tariffs could threaten the U.S. consumer, capex cycle, and broader economic cycle. We are already seeing this in weakening manufacturing data.
However, tariffs can be pulled off with the flick of a wrist, and if the U.S. and China can come to a trade agreement that avoids additional tariffs and removes those already in place, we would expect the global economy to reaccelerate. Low interest rates globally increase the relative attractiveness of equities and historically have supported higher multiples. Low rates also help stimulate cyclical areas of the economy like autos and housing; the average 30-year fixed mortgage rate in the U.S. according to BankRate.com is back below 4%.
And then there is central bank action to consider. In our view, the equity market is looking through this slowdown and expecting the Fed to engineer a “soft landing.” In other words, the equity market is pricing in that the Fed will do a series of “insurance rate cuts” to stimulate the economy and extend the cycle, similar to the mid-1990s. This may indeed be what occurs, but if the trade tensions do not deescalate, we would expect a bumpier ride.
Some comfort can be taken from measures of equity investor sentiment, including the AAII Bull/Bear indicator and Bank of America fund manager surveys, both of which suggest equity investors are expressing a degree of caution.
In May we reduced our longstanding equity overweight to neutral versus our strategic benchmark and increased our allocation to fixed income. The U.S. manufacturing sector is slowing, but the services sector and consumer are still holding up well. While the bond market is signaling a more negative scenario than our base case, we also think the equity market is a bit too complacent in the face of mounting risks. The binary nature of the U.S.-China trade talks, which remain one of the most pivotal inputs to our economic assumptions, and the competing tensions in the economic data, are supportive of a neutral allocation to risky assets at this time. We stand ready to adjust that allocation in either direction as the economic data and trade developments unfold.
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