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Question of the Week - July 11, 2016

Question of the Week - July 11, 2016

Guest Post - Monday, July 11, 2016

Stock and bond markets seem to be flashing different signals about the economy. How should we interpret this?

While both stocks and bonds often have predictable reactions to geopolitical events and economic data, there are also some unique drivers. A period of very low interest rates has caused some unusual dynamics to occur, but the results aren't entirely surprising considering their sources.

Bond investors generally seek safety and income. It's been said that bond managers are eternal pessimists, which they can't be blamed for, as bonds tend to perform best in weaker economic conditions that correspond with falling interest rates. Accordingly, an expectation of weaker growth sends investor flows from risk assets to bonds, assuming there is some yield as compensation for making that move to safety. Today, there is very little. Outside the U.S. especially, this represents an interesting case, and one we've discussed before in regard to the unique situation of bonds with a negative interest rate. Again, the only time that such a purchase makes sense is if the buyer is a trader and expects a yield of -0.10% to fall lower to, say, -0.20%, and could earn a capital gain upon selling the bond under the 'greater fool' theory. Another case is if a purchase is made by a less price-sensitive party, like central bank or pension, where a structural mandate requires ownership of certain sovereign bonds at all times, regardless of how attractive they are or aren't. Otherwise, buying bonds with negative yield-to-maturity guarantees a loss if held to maturity, and one is better off hoarding cash. To the extent hoarding large amounts of cash isn't practical is where the decision at the margin is made about what to do about 'safe' assets.

Long-story-short, this explains some of the flows into U.S. bonds of all types—treasuries, agencies, and corporates. This has even affected muni markets, strangely enough, which don't usually attract much interest whatsoever from foreign buyers, but have recently as they're another source of above-zero yield. Strong demand for bonds from a deeper pool than normal is driving bond prices higher and rates lower, so the technical aspect of this dynamic is fairly straightforward. Low-yielding U.S. bonds are the most attractive option in a global sea of sinking ships.

The dynamic of stocks is another matter. The slow global growth paradigm has affected these as well, with investors searching for growth wherever they can find it. This has explained the out performance of U.S. stocks over foreign, and segments of 'growth' over 'value' over the past few years (aside from the recent rebound of the energy/materials segment due to recovering oil prices). It's not so much the environment today that drives stocks, but hopes for what will happen tomorrow—specifically, expectations for earnings. Earnings growth has been lackluster, but lately that's been due to terrible results from the energy/materials group—other sectors have been in fundamentally better shape. Regardless, if higher oil prices trickle down to better overall market earnings, as they're expected to, earnings growth rates should eventually improve. The offset to this, however, is the condition of the overall economy, which appears to be in the mid- to later-cycle range, which could dampen hopes for strong earnings growth.

Investors have been caught in a difficult spot as of late. Since bonds aren't yielding much outright, buyers are forced to either take on interest rate risk (through longer maturities/duration) or credit risk (through lower quality) in order to improve incremental returns. Credit has been and still appears to be a better bet to a degree, but weakness in energy negatively affected the high yield bond market when oil prices plummeted, and is a reminder of the risks here (a focus on higher-quality high yield was helpful in this regard). As we progress further through the credit cycle, there may not be as much 'juice' here to squeeze out as default risks begin to increase.

Equities continue to offer stronger prospects than bonds, which is one likely reason for their higher price levels. We have come a long way from the extremely cheap post-financial crisis levels (trading below book value in some cases), and many of the easy gains likely have been made already. Stock-to-stock correlations were higher but have declined, so individual company results may again become more important than simply buying 'beta'. This could benefit active management, which has struggled in some areas versus passive index approaches in recent years. Low interest rates (and inflation), when plugged into pricing models, tend to raise the fundamental 'fair value' of stocks, which partially explains the higher multiples stocks are trading for today. Does this mean disaster? Whenever stocks rise to bubbly levels without fundamental earnings support, it can hamper future returns and raise the chances for corrections. But, if earnings improve and 'catch up' with pricing, it may just mean we plod along for a continued stretch. That can happen for multi-year periods, with price multiples stretching and contracting as expectations and market prices adjust, without necessarily experiencing an early 2000's style crumble.

Before we forget to mention alternatives, real estate in the U.S. has been one of the strongest performers of the past year, although the commercial side has been one of the least-discussed market areas. Low interest rates, careful lending practices (which is keeping supply down) and generally strong fundamentals, such as tenant demand and rent increases, are propelling the segment. There is some excitement around the late August roll out of real estate into its own specific sector of the S&P 500—being carved out of financials, although this will equate to only about 3% of the total market index. However, such moves can occur at peak levels of a segment's popularity, so it's important to keep expectations tempered.

Commodities have also rebounded strongly in the second quarter, due to a continued recovery in oil from very low levels, but also investors seeking a safe haven from geopolitical volatility in gold and silver. This asset class has different drivers than traditional assets typically, but equity markets have reacted to oil prices differently than in past experiences.

We were reminded of a basic point in reviewing a recent article about investor sentiment. There is always something wrong with the world. If conditions were ever perfect, and all data aligned in the best possible way markets hope for, pricing could rise to such expensive levels that investing wouldn't make as much sense. It's the uncertainty that creates discounts, spreads and volatility—and these create opportunity for forward-looking returns.

Read our Weekly Review for July 11, 2016.

Read the previous Question of the Week for June 27, 2016.

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