The Market Saga Heads Into Act Three

Includes: AGG, SPY
by: FP Trading Desk

If you were wondering last week if the financial world had begun to spin out of control, then Stephen Roach has a perspective that could put you at ease: We are returning to normal.

In a note to clients on Monday, Mr. Roach, the chief economist at Morgan Stanley (NYSE:MS), argued that we are now witnessing the second part of a three-act "normalization saga" as the world continues to adjust to the bursting of the dot-com bubble in 2000.

Act One entailed slashing short-term interest rates to generational lows to head off the threat of deflation. In the United States, this threat pushed the Federal Reserve to cut rates to just 1% and hold them there for a year. In inflation-adjusted terms, rates were actually in negative territory for three years, until 2004.

We are now fully immersed in Act Two, with central banks hiking interest rates, with the stock and bond markets both attempting to adjust to the new environment.

This adjustment was clear last week, when the yield on the 10-year U.S. Treasury bond jumped above 5%, and investors were left to fret over the possible impact on equity valuations. Some observers noted that when yields rise above 5%, investment dollars can shift from stocks to bonds, creating stock market volatility.

Last week, the slope of the yield curve also returned to normal, with long-term bonds yielding more than short-term bonds - possibly because of the anticipation of stronger economic growth. Previously, the yield curve had been inverted, an unusual condition that points to slower economic growth.

Now, Mr. Roach believes we could be on the way to Act Three, in which more attractive bond yields cause investors to retreat from higher-risk assets. After all, if you can get more than a 5% return from an ultra-safe government bond, why risk losing your shirt on higher risk investments such as corporate bonds or emerging market stocks?

"There is no inherent reason why these assets deserve special exemption from a financial market normalization," Mr. Roach said in his note. "Risk assets need to be priced for risk."

Exactly how this third act plays out depends largely on what inflation does. If inflation takes off and central banks are forced to raise rates aggressively, then investors would see a lot more volatility in the near future, with the higher rates eating into corporate profitability.

But if inflation stays tame, the third act could end early and without causing too much disruption. For his part, Mr. Roach is cautiously optimistic on the inflation front, pointing to the ongoing impact of cheap Chinese and Indian production.

"With these pay rates still only about 5% of manufacturing wages in the West, the global labor arbitrage remains very much intact, as does its ability to continue to push world prices lower," he said.

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