Right now, it appears that stocks and bonds are expecting a different future, one more robust than the other.
As usual, the situation is more complex than that and includes, among other things, not only what corporations are doing in terms of stock buybacks but also on the Fed.
Furthermore, the economic and financial environment are much different than they were over the past decade and investors are going to have to adjust for his difference.
Michael Mackenzie, in theFinancial Times, writes:
Major government bond and equity markets reflect contrasting outlooks for the world economy. The rebound in equities, credit and commodities such as oil, suggests a reassurance that growth will overcome a soft patch and gain altitude later this year.
The message from government bonds is different. With the amount of global negative-yielding debt back above $9 trillion and at the highest since late 2017, bond investors are less confident that the growth and inflation expectations of leading central banks will materialize.
The pessimism hit the bond market last November.
The yield on the 10-year US Treasury note hit 3.25 percent on November 8, 2018. The two estimated components of this yield, the expected real rate of interest and expected inflation, were at 1.15 percent and 2.10 at that time.
The S&P 500 stock index stood at 2,807 at that time, only 124 points below its historical high reached on September 20, 2018.
At the start of the year, January 2, 2019, the expected real rate had dropped to 1.02 percent and inflationary expectations had dropped to 1.64 percent. The S&P 500 closed at 2,510 on that date.
On March 15, 2019, the expected real rate had dropped to 0.64 percent and expected inflation had climbed back to 1.95 percent.
Thus, almost the whole drop in the yield on the 10-year US Treasury note came from the drop in the expected real rate, a decline of almost 50 basis points, while the decline in inflationary expectations was just 15 basis points.
Conceptually, the expected real rate of interest is tied to the expected real rate of growth of the economy. If investors believe that the expected real rate of growth of the economy has declined, then this will be reflected in a decline in the expected real rate of interest.
From these data, one can argue that in November, participants in the financial markets had a significant change in mind about the future of the US economy. Economic growth was expected to decline, as was inflation.
This change in attitude also impacted the stock market as well as the bond market.
The S&P 500 stock index took a tumble and hit a near-term low of 2,417 on December 21, 2018. The interesting thing is that expected inflation turned around. As stated above, expected inflation rose from 1.64 percent on January 2 to about 1.85 a month later and to 1.95 percent by the start of March.
The S&P 500 index rose from 2,510 on January 2 to 2,804 at the beginning of March.
Thus, even though investors saw economic growth dropping off, at the same time they believed that inflation would not fall as much as they had in December 2018.
And coincidentally, the stock market rose again as inflationary expectations rebounded. What can we give as an explanation for this performance?
Well, through the fall and into the present time, concern has been growing about world growth. And, although the Trump administration doesnt seem to think that economic growth is going to drop off, others, including market participants,seem to think that US growth will drop off as well.
This, as we have seen, has had a major impact on bond yields.
However, this negative information has not carried over to the stock market. Investors in the stock market, I believe, think that corporations will continue to buy back their stock, much as they have done over the past several years.
The element that has renewed investors confidence that this behavior will continue and will continue to increase stock prices is the fact that the Federal Reserve has apparently backed off raising its policy rate of interest this year and has also projected a stop to the reduction of its securities portfolio. Financial markets have taken this information positively, as the markets expectation of future inflation remains high.
These days, the stock market seems to be supported by corporate stock buybacks.
Michael Mackenzie, in the article cited above, writes:
Analysts at Socit Gnrale have focused on where money is flowing, and this week note that equities have risen the most in decades, but outflows from the equities asset class have been significant, caused by last years damage to portfolios.
This chimes with the money leaving US equity exchange traded funds this year, with the latest tally of outflows pegged at $17.6 billionThat leaves buyback supporting Wall Street.
This very fact has also been picked up by the Nobel-prize winning economist Robert Shiller, as he has created a second stock market ratio to augment the information contained his well know Cyclically Adjusted Price Earnings (CAPE) ratio.
… Changes in corporate payout policy (i.e., share repurchases rather than dividends have now become a dominant approach in the United States for cash distribution to shareholders) may affect the level of the CAPE ratio through changing the growth rate of earnings per share. This subsequently may affect the average of the real earnings per share used in the CAPE ratio. A total return CAPE corrects for this bias through reinvesting dividends into the price index and appropriately scaling the earnings per share.
That is, Mr. Shiller has produced an alternative CAPE to try and capture the impact of corporate stock buybacks.
If this is the case, and I believe that it is, then the stock market is being supported by corporate financial engineering and by confidence that the Federal Reserve is going to continue to support stock prices. But can the stock market be supported if the economic does turn south?
And can inflation be expected to remain around 2.0 percent in an economy that is just growing over 2.0 percent per year?
This seems to be the setting for 2019. But take note that 2019 is an entirely different environment than was faced in the 2009-2017 period of economic recovery.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.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.