I think the S&P 500 should be at 1900 today. Except that I don’t. Because if the stock market “should” be trading -33% below its closing level on Monday, then it would be, or at least somewhere close to these levels. Same with bond yields. I keep hearing for so many years now about how bond yields should be so much higher than they actually are today. But instead of making bold proclamations that the stock or bond market should be trading somewhere vastly different from where they are presently, we are better off taking the time to understand and explore why stocks and bonds persist in their current state and what may cause them to finally begin to deviate from the patterns that they have been following for so long now.
I am a fan of Jamie Dimon. When it comes to financial industry CEOs, I think he ranks among the best of the group. I’ve followed his career dating back to before his departure from Citigroup (NYSE:C). I can still remember riding the train out of Philadelphia nearly two decades ago and reading about his becoming CEO of Bank One, as I considered the idea of buying the stock at the time in part because of the news. And I have owned shares of JPMorgan Chase (NYSE:JPM) along the way since. But like any accomplished and outspoken corporate titan, he is also given to making bold calls from time to time. And his latest, from this past weekend, is one with which I firmly disagree in a number of (but not all) respects.
The following is the summary of Mr. Dimon’s comments in Aspen, Colorado, on Saturday, according to Bloomberg:
“I think rates should be 4 percent today”
“You better be prepared to deal with rates 5 percent or higher - it’s a higher probability than most people think.”
- "Jamie Dimon Warns of 5% Treasury Yields," Bloomberg, August 5, 2018
Bold prediction indeed. Over the past decade, some of the most renowned and admired investors in the business have come forward with their bold statements about bonds and the direction of interest rates. This includes Warren Buffett, Bill Gross and Jeff Gundlach, among others. Invariably, the predictions are almost always about how Treasury yields either should be much higher or are inevitably going much higher sooner than people think. While this is not the first time Mr. Dimon has thrown his hat into the higher Treasury yields ring, his latest comments from over the weekend in Aspen not only reinforced his daring call but doubled down on it by throwing the 5% gauntlet on the table.
Putting such calls into context. While I find it somewhat amusing how freely investment industry leaders can make such casual predictions about what “should” be happening in markets without any repercussions or pushback from the financial media, it quickly becomes less humorous when one considers the implications of exactly what is being said by such passing remarks. For example, could you imagine the market reaction if Mr. Dimon proclaimed, as the CEO of a major financial services firm, that the S&P 500 Index should be trading at 1900, or lower by roughly one-third, instead of where it is today at around 2850? Because this is effectively the stock market equivalent of his remarks. Put simply, the financial media would be going nuts, not to mention the potential impact on stock prices themselves from reactive investors that respect his opinion.
Mr. Dimon, a follow-up question, if I may... OK. But let’s just take Mr. Dimon’s proclamation at face value that the 10-year U.S. Treasury yield should be at 4% today. My first follow-up question is, “Why exactly?” Maybe they “should” be at 4%, but they’re not. In fact, they are nowhere close to 4%. Instead, they remain stuck below 3%, where they have been trapped for the better part of seven years now. Given the vast chasm that exists - the difference between a 3% yield and a 4% yield on 10-Year U.S. Treasuries is a big deal - coupled with the insights that come with being the leader of one of the largest financial institutions in the world, perhaps the better question would be to ask why they are not at 4%, or anywhere close to 4% for that matter.
Be prepared, but also pragmatic. As for his follow-up point that we should be prepared to deal with rates that are 5% or higher, on the first part I could not agree with him more. Investors should absolutely be prepared to deal with the 10-year U.S. Treasury yield rising to 5% or higher. Being prepared is a critical part of prudent investment management that is often overlooked by so many investors, particularly in today’s momentum-fueled market. So, on this point, I think he is exactly right. But just because we are prepared for such an outcome by considering the possibility does not mean that we should expect it. And I would assign a far lower probability to rates climbing to 4%, much less 5% or higher, anytime soon.
The case for higher rates. I get the case for higher interest rates. The U.S. economy is accelerating, and with it will come inflationary pressures. Knowing that inflation is the sure-fire bond killer, Treasury yields will rise accordingly. And with monetary policymakers potentially behind the curve in tightening monetary policy under such a scenario, the Fed will be forced to raise interest rates more aggressively, thus forcing interest rates even higher. Got it. Except I’m not seeing much of any of this unfolding at the present time based on the underlying data.
What about the raging economy? Yes, the U.S. economy is doing well right now. The latest reading on economic growth for 2018 Q2 just topped 4% and stands to get revised higher before it’s all said and done. Unemployment is at historic lows below 4%. And we’re finally starting to see green shoots on the wage growth front in recent months. But it still remains to be seen whether what we are seeing play out in the economy right now is anything more than a fiscal policy-induced sugar high, thanks to the corporate tax cuts from the end of last year. After all, I remember the accepted narrative of a globally synchronized economic recovery as recently as the start of this year that turned out to be nothing more than a monetary policy-induced fantasy once the tide of central bank stimulus dollars started receding.
The case for NOT higher rates (or even lower rates). Let’s begin with the economic outlook. Despite the hot Q2 number, the consensus forecast is for economic growth to return below 3% as soon as the current quarter and toward 2-2.5% by early next year. As for employment, a look at the following chart below has to raise an eyebrow even for the most optimistic among us, as the current unemployment rate is already at or below the levels that preceded nine out of the last nine recessions.
I look at the core inflation rate and can concede that it has perked up a bit as of late. But then again, it’s not any higher than it was back in 2012 or 2016 (or the first half of 2008, for that matter).
And when I consider the chart showing forward inflation expectations as measured by the 5-year breakeven rate, not only are we no higher today then we were back in 2010-2013, but inflation expectations have actually been steadily fading back below 2% for the last two and a half months after peaking on May 15 at a scorching (he writes sarcastically) 2.15%.
Then I come back and look at the yield curve - which, while tired in its use as of late, is still a worthwhile reading for financial market monitoring purposes - that continues to tell the tale, despite its recent blip of steepening, not of an economy accelerating into a higher inflationary gear, but instead, one that is gradually descending toward recession.
Then I consider how the spreads of our 10-Year U.S. Treasury yields stack up against those safe haven sovereign debt alternatives that are on offer from places like Germany and Japan. Already, global investors are getting paid a historically high premium for investing in U.S. Treasuries. While certainly possible, it is difficult to imagine another one to two percentage points being added to these premiums without global yield demand intervening along the way.
Overall, all of these important charts are not supportive of the accelerating growth and higher inflation thesis that would be good for stocks and bad for bonds. On the contrary, they are instead suggestive of persistent deflationary pressures and a potential recession lurking on the horizon, both of which are bad for stocks and good for bonds. Not saying a recession should happen, but we should be prepared for the possibility given that historically they used to take place every three or four years, before central bankers got actively involved in trying to micromanage the business cycle a few decades ago.
But what if yields still end up going to 5%? As I mentioned above, regardless of whatever might make logical sense or not, investors should still be prepared for any possible outcome. After all, I could make a sound case that the S&P 500 Index trading at 2850 in August 2018 is completely illogical, yet here we are today at 2850. What, then, are the implications if we see the 10-Year U.S. Treasury yield rise to 4% or 5%, or even higher? Clearly, such an outcome is bad for bonds, as the downside pain is shown right there in the yields (as we all know, prices move inversely with yields when it comes to bonds). But what about stocks?
“Still, Dimon remained positive on the outlook for financial markets.
The current bull market could “actually go for 2 or 3 more years” because the economy is still doing quite well and markets usually turn right before the economy, he said.”
- Jamie Dimon Warns of 5% Treasury Yields, Bloomberg, August 5, 2018
Mr. Dimon, another follow-up... Along with his comments in Aspen about sharply higher Treasury yields, Mr. Dimon also proclaimed a generally bullish outlook for stocks. To this, my follow-up question would be the following: “Can we really have it both ways?”
Is what is bad for the goose actually good for the gander? Such has become a common remark from investment all-stars in recent years. Bonds are going to get trounced, but the outlook for stocks is awesome! Yet, the logic behind it is puzzling, to say the least. Bond yields are going to 4% or 5% or higher, yet the stock market is going to continue rising despite this fact. Inexplicably, the financial media never pushes back on this point, but the underlying logic has its fundamental challenges.
That pesky thing known as the equity risk premium. Here’s the thing. The process of establishing and maintaining stock valuations are based in part on underlying interest rates, also known as the risk-free rate. Whether you are using the 3-month T-Bill or the 10-Year Treasury for this purpose, this rate is used to determine how much of an additional return premium is required by investors to take on the risk of investing in stocks.
That’s rich. The equity risk premium is already historically low, as implied by the fact that stocks continue to trade at some of their highest valuation multiples in history, even after factoring in the impact of the recent tax cuts. The primary justification for this premium valuation for years has been the fact that interest rates have been historically low. Thus, if rates indeed rise to 4% or 5% or higher as Mr. Dimon suggests, this rapidly escalating yield will put increasing downward pressure on stock prices as the already low equity risk premium gets essentially squeezed away to zero. That is, of course, unless stock prices were to fall precipitously to keep this equity risk premium intact as investors are instead drawn by the appeal of higher and higher Treasury yields instead.
How could stocks overcome such strong headwinds? Accelerating economic and profit growth that is running sustainably ahead of the underlying rate of inflation. But show me the time in history when stocks that were already trading at above-average, much less peak, valuations were able to continue soaring amid an environment of sharply rising inflation and long-term U.S. interest rates for any prolonged period of time. Maybe for a spell in the early 1960s, but we all know how well that ended over the subsequent two decades. And as mentioned, such an outcome is not showing up in the data today anyway outside of after-tax earnings (it’s not even showing up in before-tax earnings as of yet in any meaningful way).
The next time you hear a bold call made in a more casual setting from a financial industry all-star, definitely take them for all that they are worth. But also take the time to carefully think about the specific merit and actionability of exactly what is being said. For unless such strong claims are accompanied by a detailed analysis explaining why, they at minimum require much more careful consideration and doing your own homework before taking any action.
Mr. Dimon may very well be right in his predictions, when it’s all said and done. We may very well see the 10-Year Treasury yield back above 5% and the S&P 500 Index trading north of 3500. But such an outcome, in reality, would requires a fair amount of needle-threading and abrupt trend reversals along the way. For at the present time, many economic and market indicators simply do not support such a bold prognostication playing itself out. So, while Mr. Dimon has every right to believe that 10-year Treasury yields “should” be at 4% and could move above 5%, such a claim is no different than claiming that the S&P 500 Index “should” be trading at 1900. Perhaps both of these things “should” be true, but they are nowhere close to actually being true at the present time, and we have no indication as of yet on either front that we are heading in this direction.
Instead, forces appear to be continuing to converge suggesting the exact opposite may be preparing to play itself for bond yields over the next twelve to eighteen months, with Treasury yields falling back lower, along with U.S. stock prices also potentially relenting to the downside (not necessarily to 1900 or anything close to it, but lower - we have to see how things play out along the way). I’m not saying this “should” happen, but probability is increasingly suggesting that it may happen. And investors should be prepared for how things may play out gradually over time on each step of this or any other possible journey along the way.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Retirement Sentinel makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Retirement Sentinel will be met.
Disclosure: I am/we are long TLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks as part of a broad asset allocation strategy.