The S&P 500 benchmark is in record territory at 2,161.74 after setting four consecutive records this week, a streak that was fourteen months in the making. The Dow Jones Industrial Average posted similar gains and record book accolades closing the week at 18,516.55. On the bond side of the ledger, the 10-year Treasury note hit an all-time low yield of 1.37% earlier last week while the spread between the interest rate sensitive 2-year note and the 10-year note fell to 0.76 percentage points-the lowest spread since November 2007.
Since then market resilience has been on display as the 10-year yield has recovered to 1.59% at Friday's market close (15 July) with the 2-year note posting a 0.673% yield for a spread of 0.92 percentage points-the highest spread since the 24th of June, the day after the British referendum vote. Consumer spending increased smartly in June, up 0.6% from May and up 2.7% on June 2015. Still, bonds continue to rack up unprecedented levels of capital gains for the year throughout the developed world. And with the likelihood of rates in Europe and Asia falling deeper into negative territory as the year progresses, bondholders continue to wince at the squeeze on yield income-sending bond valuations even higher. Meanwhile, Western Texas Intermediate crude is up just under 25.99% for the year at $46.13/barrel, yet still well off a May 2015 high of $62.54. Brent crude is up a similar amount on the year at $49.56/barrel through yesterday's market close and almost equally off its May 2015 high of $69.52/barrel. And all is quiet on the volatility front as the CBOE VIX wallows at a quiescent reading of 12.67-just over 38% off year-to-date and almost 35% below its long-term average reading just shy of 20. How should we interpret such disparate market indicators?
Historically, the bond market has always served as a barometer for both economic growth and price inflation in the greater economy. With the spread between the interest rate sensitive 2-year and 10-year Treasury notes at 0.76 basis points at Friday's market close (8 July), the bond market was signaling a high probability of a recession in the next 6 to 12 months. With short-term yields locked beneath 1% for all Treasury issues up to 5 years and the 30-year bond yielding a scant 2.18% through Friday's market close (8 July), the resulting yield curve is remarkably flat at the start of year eight of the official recovery period. The probability of such an uptick in 2016 was negative.
Fast forward one week and market expectations on an increase in the federal funds rate have risen sharply over the course of the past week, soaring from negative numbers to a 20% probability of an uptick in the federal funds rate by year's end. Meanwhile, market based measures of inflation come in at 1.52% in ten years' time. With 10-year treasuries negative in Japan, Germany, Denmark, Switzerland and the Netherlands investors in these markets are guaranteed to lose a portion of their principal at maturity. The statement lacks precedent in financial history.
Rather than signaling an ensuing economic train wreck of global proportions, falling bond yields are more reflecting the supply and demand for safe assets across the developed world. Central banks have by far and away become the largest players in many of these markets. The large-scale asset purchase programs (LSAP) currently being run by the ECB and the Bank of Japan (BOJ), coupled with concluded programs by the Federal Reserve and the Bank of England (BOE) have taken trillions of dollars of government debt out of circulation in a concerted effort to spur growth in their respective economies. The unprecedented rally in government debt continues-simultaneously driving yields to historic lows. Estimates of government debt trading in negative territory are now in excess of $13 trillion worldwide. This week, Germany became the first euro-zone country to sell a 10-year treasury note with a negative yield at auction. Also this week, fellow EU-member state Switzerland auctioned off 42-year bonds at a 0.02% negative yield.
The flip side of this unprecedented demand for safe assets is an equally unprecedented lack of a fiscal response by governments to meet chronically sclerotic levels of economic growth across the developed world. The unusual combination of central bank purchases with falling issues of sovereign debt has created pronounced shortages of high quality government debt, driving the price of such debt ever higher and yields ever lower. The shortage of available high quality debt in Germany is further accentuated by the government's balanced budget aspirations which appear at first glance to be working at cross purposes with current ECB asset purchase programs to spur economic growth in the euro-zone. Interestingly, a change of heart on the fiscal side of the equation would cause immediate financial pain for investors large and small as prices fall and yields rise in response to the increase of supply. Be careful what you wish for.
The impact of negative rates from Europe and Japan have been washing up on US shores for some time now and in the immediate aftermath of the British referendum the pace has turned into a furor. The yield on the yield on the US 10-year Treasury note stood at 1.74% on the 23rd of June before the British referendum, falling to an all-time low of 1.37% by the 5th of July in reaction to the vote. The economic uncertainty surrounding the myriad issues brought to the fore by the Brexit vote has created economic headwinds of unknown proportions as expectations on global growth and corporate profits derived from international, particularly from British and EU, markets are quickly being adjusted downward. The IMF downgraded euro-zone growth projections by 0.3 percentage points to 1.4% in 2017, citing Brexit concerns.
Last week's appointment of Theresa May to the office of prime minister removed an important slice of the political dimension of the uncertainty equation months before expectations. Equity markets worldwide responded favorably to the expedited appointment with solid market gains albeit of questionable sustainability. Prices on bonds fell and yields inched higher as some investors flipped bonds for equities, coaxing the S&P 500 benchmark to a new market highs. Still, the reality of unwinding 43 years of inseparable marriage while simultaneously forging a future arrangement with the EU presumably of a more platonic nature that at the same time will muster the necessary unanimity of 27 jilted national parliaments across the Channel--is a task of biblical proportions. Predicting the impact of Brexit at this early stage in the process relies necessarily on readily observable anecdotal evidence due to the time lag of official economic data which is further complicated by the surprising dearth of contingency planning for such an electoral outcome in both the public and private sectors. Suspending redemption requests from six leading investment funds holding British commercial properties are likely not an auspicious start. Chocolate futures (CHOC) have soared on the heels of a chastened pound while the purchasing power of foreign tourists visiting the Britain has been much enhanced. The BOE surprised investors at the conclusion of a regularly scheduled meeting of the Monetary Policy Committee (MPC) on Bastille Day by standing fast on interest rates with a surprisingly lopsided 8-1 vote. Meanwhile, the MPC statement at the conclusion of its meeting all but promised such an interest rate adjustment at its August meeting and possibly more as data rolls in between now and then. There is even early talk of a fiscal response by the newly installed Theresa May government. Yet with a current budget deficit of about 4% of GDP, options on this front are likely limited. Suffice it to say, history will be hard-pressed not to crown the Brexit vote as the country's biggest economic and political debacle since the Suez crisis in 1956. The shroud of uncertainty will cast a long shadow over investor sentiment for the foreseeable future. A similar arrangement spelling out Canada's access to the EU single market took seven long and arduous years of negotiations to complete and now faces the equally arduous task of securing unanimity in same 27 different EU national parliaments, not to mention 9 Canadian provincial parliaments. Meanwhile, institutional capital inflows to dollar-based assets and treasury debt continue apace.
And then there is the issue of weak capital investment. Non-residential capital investment has declined for two consecutive quarters through the end of the 2nd quarter-the first such back-to-back decline since 2009. Much of this decline is result of the unprecedented pullback in oil and gas investment that has lopped an estimated $1 trillion from forward capital spending through 2020 worldwide, according to Wood MacKenzie data. In the face of weak demand for goods and services and presumably narrowing investment opportunities, US corporations have responded by driving share prices not through the expansion of plant, equipment or advanced workplace efficiencies but through programs that enhance shareholder value through share buybacks and dividends. Some of the biggest and most valuable companies in the S&P 500 sit on piles of cash, reserves that find few productive opportunities in current low interest rate environment. These reserves are the same future earnings that investors are now forced to pay more for to fund future income streams.
So why would investors even consider buying negative yielding bonds that guarantee losses of principal at maturity? Many institutional decisions to purchase high-quality debt have made demand for such assets inelastic in nature, with issues of return and performance becoming secondary considerations in the purchase process. Banks purchase high quality assets to meet the requirements of regulators who closely monitor the level of allowable risk on any given balance sheet. Compliance obligations require insurers to purchase high-quality debt to meet its contractual obligations to clients at distant junctures in the future. Similarly, pension funds purchase long-term high quality bonds to meet clients' retirement expectations. All of this creates demand for bonds irrespective of current yield or price. This simple paradigm is held together with the belief that central banks will prevent an economic train wreck by backstopping the process with monetary policy-if and when needed. Yet with the spectacular misjudgment of voter sentiment in the Brexit referendum and Thursday's near certainty that the BOE would lop 25 basis points off of borrowing costs to stabilize the British economy, investor expectations have taken some punishing blows of late that certainly instills pause.
On the equity side, a low interest rate environment that has literally emasculated yields on both government and corporate debt issues coupled with a strong dollar in world currency markets will continue to squeeze future corporate profits. What that portion of future earnings is worth is a reflection of current investment options and their perceived ability to generate future income streams. As viable investment options narrow, especially in prolonged low or even negative interest rate environments, investors are forced to accept higher price-to-earnings ratios for a piece of those future earnings. This is why high dividend paying stocks will continue to look so attractive. It takes little study in rocket telepathy to discern the difference between the yield of a 10-year US Treasury note and that of a similar duration Gilt or Bund or Japanese notes. This explains much of the capital inflows to dollar-based assets and US debt issues. The same analysis holds comparing bond to equity yields. The yield of a 10-year US Treasury note pales against the annual yield of Consolidated Edison (ED) at 3.55%, or against alternative energy financier Hannon Armstrong (HASI) at 5.3%, or against Duke Realty (DRE) that carries a yield of 3.18%, or against the Canadian telecom company BCE (BCE) with a 4.46% yield. The list is hardly exhaustive. With government debt being so richly valued, the paper's "risk-free" status almost becomes an oxymoron as a sharp correction could cause quick and acute financial pain over large swaths of the investment world. It is little wonder that utility issues in the S&P 500 are up 20% for the year and trade at about 21 times their 12-month trailing earnings, well above the sector's 10-year average earnings of 15, according to FactSet data.
In the post-WWII era, the yield on the 10-year Treasury note has consistently outpaced the dividend yield of S&P 500 companies. By the advent of the Great Recession of 2007, asset purchases by central banks throughout the developed world flipped the paradigm on its head. LSAP programs by central banks have not only inflated the price of assets throughout the general economy, they have made stock cheap relative to bonds. Among other things, monetary policy pulls future earnings back to the present in an effort to stimulate current economic growth-with the hope that current growth will stimulate current capital investment in future economic growth. With capital goods investment so weak, such a pullback strategy invites real-time questions. While current earnings ratios of stocks are indeed higher when compared with historic measures, prevailing interest rates are hundreds of basis points lower today than in years' past-explaining much of the difference between current and past equity valuations. The lower bond yields fall, the greater the attractiveness for high yielding equity issues. Short of central banks' raising interest rates and beginning the process of removing the copious levels of liquidity in their respective economies, the seeming dichotomy of bonds and equities will remain a fixture of our investment environment for the immediate term and beyond.
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