Download 20 June 2017 Swanson: Stocks and Bonds: Two Markets Telling

Strategist’s Corner
20 June 2017
STOCKS AND BONDS: TWO MARKETS
TELLING DIFFERENT TALES
James Swanson, CFA
MFS Chief Investment
Strategist
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.
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Strategist’s Corner / June 2017
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
subject
to change
at any
time.
These
views
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areare
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These
views
areare
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relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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