Capital markets are fighting over how economy is faring — and they’re probably both wrong
The truth is somewhere in between the outlooks of bonds and stocks, Tom Bradley says.
There’s an interesting debate going on in the capital markets right now.
On one side is fixed income. The “senior market,” as it likes to be referred to, asserts that there is serious trouble ahead. It points to rising government and corporate debt, potential disruptions to global commerce (Brexit, trade disputes) and increasing signs of recession. It notes that interest rates, that were already at recessionary levels a year ago, are now a full per cent lower. In summary, “Look out below.”
The worthy opponent in this debate represents stocks, high-yield bonds and loans and other risk assets. Its argument is simple — “Be it resolved that everything is just fine.”
It offers the strength of the
U.S. consumer as evidence that a recession isn’t imminent. It takes reassurance from stock indexes flirting with new highs, growth stocks trading at healthy valuations and emerging companies going public despite no promise of profits. And it points to spreads on high-yield bonds and leveraged loans that are near historical lows. In summary, “Why worry?”
For context, this kind of disagreement is not uncommon. It happens from time to time, although the current version is more extreme and extended than any that I can remember. While it seems to defy explanation,
I’m going to give it a try. Here are some possible reasons why bonds and stocks are promoting such different outlooks.
CENTRAL BANKERS HAVE OUR BACK
Rate cuts are usually a response to economic weakness, or the prospect of it, but investors don’t have to worry. Since the Greenspan era at the U.S. Federal Reserve (1987 – 2006), there’s ample evidence that one of central banks’ priorities is to prevent negative returns and keep investors happy. Equity investors take comfort that every time the economy wobbles, central bankers in North America and Europe come to the rescue.
THE TREND BECOMES AN INVESTOR’S FRIEND
A profitable strategy in recent years has been to buy what’s working and hold on to it until it isn’t. It’s called momentum investing and it’s becoming a bigger part of the markets. For these investors, the bond market’s message falls on deaf ears. Until the trend is broken, stocks are where it’s at.
THE STOCK MARKET ISN’T AS ROBUST AS IT LOOKS
The market indexes are being led by a narrow group of stocks. They’re pushing the market higher while the rest are doing a whole lot of nothing. In retailing for instance, Amazon is up over 50 per cent since the beginning of 2018 while in aggregate, the other retailers are flat.
THIS IS THE NEW NORMAL
Interest rates are not going back up. They will stay low, especially given the high levels of government and consumer debt. We’re entering a new paradigm where bond investors are willing to lend money knowing that they’ll be worse off when they get their money back (after adjusting for inflation). Veteran investors like me need to get with the program.
In turn, negative real interest rates mean valuations on stocks and other assets are easily justified. As the argument goes, future earnings are worth more when discounted at a lower rate, so price-to-earnings multiples will stay where they are or go higher.
TINA — THERE IS NO ALTERNATIVE
Interest rates are so low, and so uncompetitive, that investors have no other place to invest. Stocks are it.
Maybe the most likely explanation for the divide is that both sides are wrong. The economic and market outlook isn’t as gloomy as the bond market asserts nor as rosy as the stock market implies.
The truth is somewhere in between.
Clearly, traders and market commentators are hanging on the resolution, but long-term investors need to put the debate in context. For you, it’s a side show. The most important drivers of investment returns are a consistent asset mix, an unwavering schedule of contributions and a reasonable fee. After all, during the course of your investment career, both sides will claim victory multiple times.