This commentary is more technical in nature than what we usually write. We suspect some of you, our clients, may not fully read it all and that’s okay – we won’t be insulted. The quick summary is this: bond markets and stock markets usually move opposite to each other, hence their diversification benefits. Today, they appear to be indicating the same thing by moving strongly upward together. One of them must be wrong. Historically, the smart money is the bond market viewpoint. Yet today, central banks are distorting true risk and value by their market operations. The bond market is likely saying that recession is coming. This leads us to continue our shifts to a more defensive portfolio posture.
For those of you who may enjoy a more detailed explanation of how we are thinking, please feel free to carry on.
“Today, both are flying high, celebrating the times we are in. Is this normal? Why is it happening and can it last? “
It would appear to us that, right now, the stock market and the bond market are each predicting two different outcomes. These two markets are usually negatively correlated with each other. When economic times are booming and confidence is high, stocks surge ahead leaving bonds to lag as interest rates are increased to slow the exuberance. When growth stagnates and fear abounds, interest rates are decreased to stimulate the economy again and bonds perform well, leaving stocks to wallow. Today, both are flying high, celebrating the times we are in. Is this normal? Why is it happening and can it last?
In an attempt to answer these questions, let’s review where we are and how we got here.
The S&P 500 (a broad measure of the US stock market) closed its first half of 2019 at an all-time high. Given all the “noise” surrounding slowing growth rates, tariffs and trade wars, earnings growth decreases and questions about fiscal policy stimulus, this has been quite the feat. While rates have risen recently, we’re now right back down to lows not seen in decades. The stock market is excited about the future and the bond market is saying the exact opposite. Historically speaking, this situation is not going to last.
However, and while we really hesitate to even suggest this because most of the time it’s false, maybe it is different this time around. Why? Central banks. All around the world, it seems like they’ve changed the way the game is played. Rather than being the referee guiding the players from the sidelines, they’ve actively joined the game on the field as major players. While they’ve always guided monetary policy (interest rates and money supply) and influenced government spending funded by debt (now via the printing presses otherwise known as Modern Monetary Theory) we have seen new actions like quantitative easing (QE) and other structures like TARP and TALF created to clean debt out of the market that likely wasn’t going to be honoured. These are all fancy tools for one basic intent: buying bonds (debt) out of the market where it can’t hurt participants if it’s defaulted on. The effect of buying all these bonds is that their prices have been pushed higher. When a bond’s price increases, its yield to maturity decreases. This is one major reason why we see rates so much lower today.
These low rates have caused those investors who need yield for their income needs to search for it in other places. Bonds that have greater risk embedded in them (and therefore higher rates) are being bought without as much regard for their inherent risk and even their yields are dropping. Some very risky debt, that 10 years ago would never be held by conservative investors (eg. Greek sovereign debt or State of Illinois bonds), are now being bought without the same regard for preservation of capital. Further, investors who otherwise would avoid stocks are venturing into ‘safe’ stocks with dividend yields to satiate their hunger for yield and income. All this buying is pushing prices upward without the same regard for safety and risk management. Given the actions of central banks and these ultra-low yields, most investors don’t really have any choice.
Even now, the markets expect rates to drop further. This was reinforced recently by Mario Draghi of the European Central Bank who reiterated his promise from years ago that they will “do whatever it takes” to bring back sustained inflation. This means, continued bond buying to lower the quantity of bad debt in the market and to drive interest rates further lower to bring about growth. In fact, all this buying of bonds has pushed many to yield negative interest over their term to maturity. Yes, you’re paying someone for the right to give them your money. Why would anyone do this? They’re effectively saying that they place a large premium on assets that are safe and liquid. Sure, they could profit from foreign exchange via interest rate differentials and roll-down return, but that’s for another article. More to the point, they’re also saying that if the economy does deteriorate, stock markets will drop more than the negative yield on these safe assets and so even though they will lose, they will lose less. Lastly, they may also be expecting central banks to reengage in bond buying thus becoming a massive buyer in the market, pushing up the price of these bonds and thus realizing a gain for themselves.
Wow, did you catch all that? The game does seem to have changed. If you expect a large central bank to come in as a buyer (remember: the referee is now on the field playing alongside you) and this buyer is willing to pay any price, you’re likely not as concerned about the price you pay now nor the default risk you’re taking should you hold the debt to maturity. We’re likely seeing a lot of bond buying with speculation that someone else will take it off their hands at higher prices. This demand masks the true risk of the underlying assets. What normally prices at a discount due to its inherent risk, is now pricing to near perfection. On so much unrepayable debt, some thing, some time will certainly give.
“We’re likely seeing a lot of bond buying with speculation that someone else will take it off their hands at higher prices. “
What does this mean for investors and our portfolios?
First of all, remember that the price of an asset is most simply, the present value of the sum of its future cash flows (yield for bonds and earnings for stocks). This is known as the classic Dividend Discount model or Discounted Cash Flow model. This is true for real estate rents, bond interest payments and stock dividends and earnings. All of these assets we buy today are being discounted at ultra-low interest rates. When you do that, the math calculation results in a higher present value and so the price of the asset is fundamentally higher. These high valuations are presently justified given these low rates and low inflation. If rates stay low, the elevated valuations can remain high. If rates rise, there would then be a headwind for valuations given the higher discount rate. However, usually rates rise alongside inflation and growth, so we’d also expect to see corporate earnings increase, which might actually support these higher valuations.
As you can see, it’s not always a clear-cut answer. That said, the disconnect between bond markets and equity markets today strikes us as odd and is disconcerting because both believe they are right. Even considering how responsive central banks have been and promise to be, we suspect the economy and markets can and will change faster than they can react. It’s just the nature of the world we live in. It appears that there is a greater probability of recession today with earnings growth slowing, the yield curve inverted, and manufacturing and other leading economic indicators starting to flash early warning signs. While this could still be a ways off, we continue to feel that it’s wise and prudent to be cautious. Early in my career, I remember learning that one is always wise to watch the bond market, not the stock market, even though it is quieter and less flashy. That is what we’re doing today.
As our recent quarterly commentary indicated, we remain neutral in our bond market and equity market stance, whereas we were overweight equities about a year ago. Our equity portfolios continue to favour higher-quality companies with stable earnings and strong cash flows with lower debt levels. Our fixed income portfolios remain underweight short-duration debt as we favour mid-duration bonds that will benefit from further rate cuts. We greatly appreciate the Alternative portfolios as their assets (real estate, market-neutral hedge funds and gold) are not highly correlated to either bonds or stocks. Given all that we just said, that seems like a good place to be overweight and we remain confident in this position for the time being.
As always, please reach out to us with any questions you might have. We’ve never been more confident in the overall portfolio design and holdings. While we can’t control the moves of the market, we believe that holding these defensive positions over the long run will serve you well and will generate the consistent results you need to achieve your goals.
Thanks, as always, for the trust you place in us. Please feel free to share this with friends, family or colleagues. Your referrals are greatly appreciated.
Your CrossPoint Financial Team