John Hussman: Low Yields Precede Market Hostility

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the US market:

In reviewing investment conditions this week, I'm struck by the general insufficiency of yields across the investment landscape. In Treasuries, the yield curve is inverted, with 10-year yields below 3-month Treasury yields, which itself has typically been unfavorable for stocks, and much more so when the general level of yields has been depressed.

While it's true that declining yields have generally been favorable for stocks, investors should make a strong distinction between "declining" (an indication of trend) and "low" (an indication of level).

I can't emphasize enough that the most hostile periods for stocks (as well as bonds) have been those where yield levels have started at low levels and have been pressed higher. While it's true that you can squeeze a reasonable capital gain out of a low-yielding market -- by pushing yields even lower -- that's definitely not where you find sustained gains, or gains that are typically retained over the full market cycle...

As for the universally-known fact that slower economic growth means slower inflation, I would submit that it's not a fact at all:

Economic Growth vs Inflation Chart 13 11 06

The chart above shows data from 1962 to the present. The inverse relationship between economic growth and inflation (i.e. higher economic growth implies lower inflation) is not just a feature of historical data -- it's also perfectly consistent with economic theory... We may in fact observe inflationary pressures near the tail of an economic boom, but that's generally because output can't grow fast enough to satisfy demand. Faster output growth alleviates inflationary pressures.

Likewise, you get an easing of inflation when there is restrained growth in government liabilities, or investors are very eager to hold those liabilities. You see that a lot during periods of credit default and bankruptcy, because investors rush for the safety of government bonds and currency....

That's why interest rates often lead inflation (rather than simply following it). Higher interest rates are a signal of weak demand for government liabilities generally. Likewise, weakness in the foreign exchange value of the U.S. dollar can also be an indication of weak demand for U.S. government liabilities.

Presently, the inflation picture is mixed, but it's not at all clear that inflation has become a non-issue. On the side of low inflation, intermediate-term interest rates have backed off in recent months, suggesting decent demand for government liabilities. However, T-bill yields are still holding near their highs. The inverted yield curve and the weakness in the U.S. dollar in recent sessions are not favorable toward the low inflation case. The year-over-year rate of core inflation has also been increasing without interruption. Overall, it's difficult to conclude that inflation concerns have become irrelevant.

Suffice it to say that the stock and bond markets currently reflect very depressed yield levels, and that the case for lower yields is not as clear as is widely argued. While we can't rule out the potential for still lower yields, it's increasingly important to remember that the most hostile periods for stocks and bonds have typically been associated with upward pressure on yields from relatively low starting levels.

Read more John Hussman weekly essay excerpts on Seeking Alpha.