In the months following the 2016 US presidential election, US stock and bond markets moved inversely, both anticipating a pickup in economic growth. Equities rose smartly while bond prices fell, pushing yields higher, anticipating that faster growth would eventually lead to an uptick in inflation. But in the last few months, the stock and bond markets have begun to tell very different tales. Stocks have moved up unblinkingly, and bond prices have moved up as well, driving yields lower. The bond market is telling a story of lower growth and lower inflation ahead. But no one’s told this slowdown story to the stock market. It assumes nothing has changed.
The reflationary expectations that helped set stocks alight and send interest rates higher last fall have subsided significantly. In particular, hopes for a stimulative policy mix from Washington have faded as Congress and the White House find themselves sidetracked by scandals. Despite those waning hopes, equity markets have extended their advance, setting multiple record highs along the way. However, US 10-year Treasury note yields have fallen roughly a half-percentage point from their post-election highs. Why are markets telling two different tales? Let’s try and figure out which one is right.
Market’s narrow focus a worry
While I mainly focus on fundamentals like earnings growth and free cash flow generation, at times I find it useful to also take a look at technical factors. And the technical that jumps out most clearly to me at the moment is the narrow breadth in recent months of the market’s latest rally. That advance has been largely fueled by a handful of glamorous, well-known, mega-capitalization technology companies. Indeed, a recent sell-side analysis shows that nearly 40% of this year’s gain in the S&P 500 Index can be linked to just four stocks. Narrow advances have historically tended to be a warning sign. Looking back at similar periods in history, we see periods where, when just a few names led the market, outcomes tended to be less favorable than when market breadth was broad, such as earlier in this business cycle, when many stocks in the major averages were supported by record levels of free cash flow. As a technical matter, bad breadth is a cautionary sign.
Bond bull still breathing?
Long-term interest rates have been trending lower for more than three decades, but somewhat of a cottage industry has developed around predicting the bull market’s demise. And those calls reached a crescendo shortly after the election, predicated on inflation’s return, fueled by a synchronized upturn in global economic growth, low levels of unemployment and a stimulative policy mix from Washington. But markets have reassessed that call in recent weeks, sending Treasury yields lower on the back of dimming prospects for tax cuts and infrastructure spending, sluggish US growth and few signs that tight labor markets are leading to above-trend wage gains. In essence, the bond market may be trying to tell us that slower growth lies ahead.
So which market is right? While it is far too early to forecast that a recession lies ahead, forward indicators suggest we may see a mini down cycle in the not-too-distant future, not dissimilar to the three or four dips we’ve seen within the present eight-year expansion. To me, this suggests investors may want to be cautious in putting new money to work in “risky” assets such as equities and high-yield bonds.
Past performance is no guarantee of future results.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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