The Change of Seasons
By Tony Moeller, CPA
As summer winds down, the weather starts to get milder. However, just the opposite seems to be occurring in the stock and bond markets as we’ve seen increased volatility. For example, the three major U.S. stock indexes (Dow Jones Industrials, S&P 500 and NASDAQ) were up a combined average of 1.68% for the last week, which helped make up for the dismal returns in July and August when indexes had a combined average return of –1.50%.
Bonds and stocks have rallied on reports that it is almost assured the Federal Reserve will lower rates this month. Overall, investors are still pessimistic, with the current trade/tariff war between the U.S. and China, heightened fears of a slowing economy and eventual recession. This has resulted in the percentage of bears, in the most recent American Association of Individual Investors survey outnumbering bulls by 11%. Similarly, Citigroup’s Panic/Euphoria model edged closer to panic, which implies a 95% chance of market upside in the next 12 months.
Currently, the stock market is assuming there will be some sort of a trade deal with China in the next six to nine months, interest rates and inflation will remain low, and the stock market is attractive with stocks yielding more than bonds.
As of market close Friday September 6th, the S&P 500 dividend yield was 1.98%, while the 10, 20 and 30-year Treasuries yield 1.55%, 1.83% and 2.02% respectively. Prior to the recent market run-up within the past two weeks, the dividend rate on the S&P 500 exceeded the yield on all U.S. Treasuries, including the 30-year. Thus, marking a rare time when stocks yield more than government bonds. For decades prior to 1958, stock dividends topped high-grade bond yields since investors required higher payouts on stocks because in case of a bankruptcy, bondholders stood in front of stockholders for repayment.
This all changed in 1958 with investors shifting concerns that in a fast-growing inflationary world, fixed-income investors faced a greater risk of capital depreciation, regardless of their privileged position in bankruptcy/liquidation event. Until just recently, the only time U.S. stock dividends paid a higher yield than the 30-year Treasury was during the depths of the great recession, which was a great entry point for investors to buy stocks.
So just as seasons change, so do investors perception of risk/reward. Currently, it does seem ironic that longer-term bonds are an option for investors seeking capital appreciation by way of the Federal Reserve lowering rates, while stocks are being considered by those who are seeking a higher income.
Is an Inverted Yield Curve Something to Fear Currently?
The “Inverted Yield Curve” occurred on August 14th of this year and has been a hot topic ever since. An inverted yield curve is when short-term Treasuries (i.e., the two-year bond) yields more than its longer-term counterpart (i.e., the 10-year bond). Historically, an inverted yield curve has been an indicator of a slowing economy and potential recession, which are often associated with declining stocks and bear market.
An inverted yield curve is not a sign of imminent danger. Data from Credit Suisse going back to 1978 shows:
- The last five 2 Year-10 Year inversions have eventually led to recessions.
- A recession occurs, on average, 22 months following a 2-10 inversion.
- The S&P 500 is up, on average, 12% one year after a 2-10 inversion.
- It’s not until about 18 months after an inversion when the stock market usually turns and posts negative returns.
As interest rates decline, borrowers (mortgage holders for example) may refinance to lock in lower rates. Currently, institutional investors who own those mortgage bonds - banks, mortgage real-estate investment trusts and fund managers, for example - are pushed into buying longer-dated Treasuries or interest-rate swaps as the quickest and cheapest way to replace the income that disappeared with the now paid-off mortgage-backed bond.
Buying also comes from pension funds and insurers that sell annuities, because when yields fall, their liabilities often grow faster than their assets. That can increase the shortfall between what they are going to earn on their assets and what they owe to pensioners, also known as the “duration gap.” To close the gap, these businesses need more long-term assets such as longer-dated Treasuries.
The net result is that these investors are forced to buy more longer dated bonds to make up for lost income, which results in an increased demand for longer dated bonds and the issuers of these bonds to offer lower interest rates.
The Federal Reserve has kept the Fed Funds borrowing rate high in comparison to other countries, and this caused the U.S. dollar to appreciate when compared to most of its overseas counterparts. As a result, it is not surprising that U.S. yield curve inverted last month and the demand for our higher yielding long-term bonds by institutional and foreign investors have pushed our long-term interest rates down. Yes, the U.S. economy may be slowing and there will be a recession at some point but barring a complete melt down in the trade talks with China, the odds of a recession in the coming months seem remote.
What is the Takeaway for Investors?
If you ignore all the “noise” on the TV, radio, internet and in the paper regarding the economy and stock market, then you can focus on some of the facts that are not grabbing the headlines, but provide a more rational view of where we stand currently.
- Last week’s U.S. jobs report was good, and unemployment remains at 3.70%.
- Wage growth has been positive and the U.S. consumer, regardless of what you may read or hear, is feeling confident and spending accordingly. Since consumer spending is 70% of the U.S. economy, this is a very important factor.
- Inflation is low and does not appears to be rising any time soon.
- U.S. consumers are benefitting from low energy prices, especially gasoline.
- Lower interest rates have allowed homeowners to refinance their mortgages and either spend or set aside the savings. Along this line, businesses have been able to refinance their debt or in the case of larger corporations, replace old bonds with newer bonds at much lower rates. This allows the net savings to be used for expansion, stock buybacks, higher dividends or more net income to the bottom line. In any case, it is beneficial to the shareholders.
- Home sales were strong in July and when consumers buy homes, the most natural tendency is to buy appliances / furnishings for the new home.
- The appeal of a strong U.S. dollar, a resilient economy and higher bond yields has drawn the attention of foreign investors. In June of this year, foreign investors bought nearly $64 billion of U.S. stocks and bonds, which is the largest sum since August of 2018 according to U.S. Treasury Department data.
- The United States-Mexico-Canada Agreement (USMCA) could be ratified in the coming months. Since the U.S. has much greater trade relations with Mexico and Canada, as compared to China, it would be a big economic win for all involved.
- As it relates to international stocks and bonds, many other central banks are considering interest rate reductions or taking additional easing steps to help their associated economies. As a matter of fact, the European Central Bank has announced plans for a large stimulus package and China is taking steps to allow banks to lend more funds to businesses and corporations. In both instances, these steps may help boost stocks in their domestic markets.
Based upon history, the U.S. stock and bond markets could experience gains in the upcoming months. As noted above, on average U.S. stocks (the S&P 500) are up approximately 12% one year after a yield curve inversion and does not start declining until 18 months after the event. As such, we may see continued volatility in the stock and bond markets, but that does not mean they cannot inch their way higher in the coming months. Thus, taking an overly defensive position and selling stocks as a reaction to all the noise surrounding an inverted yield curve, the China trade talks or any other headline of the day, does not make sense based upon all the economic factors facing us.