Investors see an economy a one percenter Goldilocks would love: strong job creation but with factors like Brexit and the US election stopping the Federal Reserve from raising rates.
Much better-than-forecast US employment data on Friday helped send bond yields to record lows and stocks to record highs. That stocks would love an environment in which bonds are predicting little growth or inflation seems odd, but only before you take account of the impact of monetary policy.
An economy which doesn’t crater but one in which the Fed can’t hike is very supportive of the value of financial assets.
Yet in this story it is hard not to fear that rather than eating porridge Goldilocks is eating her seed corn, consuming asset price gains from far in the future rather than discounting future strong growth. The Fed seems better at raising asset prices than creating a thriving economy, one with strong investment and productivity growth. That bodes poorly for long-term equity returns while bonds at these historically low yields will only prove good value if things remain truly grim.
Add to this concerns about the dearth of investment in corporate America, where managers are prioritizing dividends and share buybacks over investment, and the whole enterprise seems less than sustainable.
Key is that while the US economy carries on creating jobs at a respectable pace, wage growth remains sub-par and overall labour market conditions, which peaked in December, are steadily deteriorating.
No wonder then, looking all the way out to June of 2017 traders see a less than 50% chance of even a single interest rate increase.
Fed policy is intended to spur consumption and investment; the latter by making financing cheap and the former by tempting investors to spend a bit of their paper wealth. The investment part isn’t working so well – there are many political and economic risks and growth seems to have shifted to a permanently lower plateau.
That leaves asset markets and the “wealth effect,” which can only help sustain consumption so long as the owners of assets believe values to be built on a solid foundation.
Bonds and equities both vulnerable
The vast majority of portfolios, individual or collective ones, are built on a mixture of bonds and equities. Despite recent market movements higher in both stocks and bonds, there are reasons to think both are vulnerable, if not to a sharp fall then to a sustained period of below-normal returns.
Regardless of your view of the immediate outlook, US stocks look expensive in an historical context. Using a price/earnings ratio derived from a 10-year average of earnings, stocks are now more expensive than they have been 92% of the time over more than a century. Not as expensive as 2007, when they were at the 95th percentile, or 1929 when they were at the 97th percentile, but expensive still.
Stocks may have moved permanently higher, and indeed corporate profit margins are very high compared to post World War 2 norms. Much of what supports that is globalization, which has both helped keep wages in check and taxes low. Brexit, as exhibit A of the threat to globalization, calls this idea of permanently higher valuations into question.
Bonds are even more expensive than stocks, with not just US 10-year yields near all-time lows but more than US$10trn of global government bonds trading at negative yields. From a portfolio risk perspective, this is very dangerous.
“Negative bond yields create intolerable business conditions for the big pools of savings in our society,” Carl Weinberg of High Frequency Economics wrote in a note to clients.
“They bankrupt pension funds, insurance companies and other big savers. Since negative interest rates are unsustainable, the inevitable snapback to positive yields will result in massive capital losses for bond holders.”
Remember, bonds may lose value, sending yields higher, not because growth returns but simply if investors stop believing that paying money to lend money is a good and safe deal. In other words bonds may do badly not because inflation comes back but despite inflation not coming back.
A scenario in which equities return little but bonds generate substantial losses is just one of the poor alternatives investors may face in the coming decade.
This isn’t a criticism of the Fed: What might have happened in a world in which the Fed had not pumped up markets would surely have been dire.
Call it what you like, but an economy which generates low growth, low inflation and low gains in productivity is not “just right”.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
