What do you have to believe to make sense of the bond and equity markets today?

Fulfilling market expectations, this week the Fed kept rates steady but was quite clear with the intent to cut soon.  There was one voting member who dissented, preferring a cut now.  It seems all markets rejoiced at this news.  Yields fell across the US Treasury curve (causing bond prices to rise) and equity markets marched higher to a record close.

So here we sit nearly in the middle of 2019 and it seems like we are stuck in the land of “twos”.  US GDP growth is expected to remain in the 2% range.  S&P 500 earnings growth is also currently forecasted to be 2% year-over-year, revised lower in recent weeks, and the 10-year US Treasury yield is hovering right at 2%.  We are looking to break out.

The Fed is not the only one stepping up their monetary game to do so.  The European Central Bank (ECB) is following the market signals of negative government bond yields by saying this week that they are likely to step up stimulus including another bond-buying program.  While Fed Chairman Jay Powell bemoans the asymmetry of not being able to get inflation above 2%, Europe would love to be in the 2% GDP growth / 2% inflation club.

As investors continuously assessing the trade-off of risk and return in asset classes, we are always looking to divine what market prices are implying about the future to see if we agree.  What kind of economic outcome must occur in the world for bond buyers to be happy with a 2% fixed rate of return on their bonds on one hand and happy to pay 17.6x the next twelve-months earnings for the S&P 500?

The only narrative we have in mind to support how both bond and equity markets can be “right” is a slow-and-steady scenario of continued modest economic expansion accompanied by disinflation (that is, inflation that is falling but remains positive).  In a future with inflation between 1-1.5%, a Treasury bond investor can earn a positive “real” return after inflation with a 2% nominal interest rate and a 5.7% equity earnings yield (flipping a P/E upside down) does not sound shabby.

Unfortunately, slow-and-steady is not a natural state in financial markets.  They have a long history of fits and starts which are often aided by policymakers.  Central banks are looking to get “symmetrical” on inflation targets (i.e. get realized inflation above target as well as below) and are willing to cut rates to make that happen.  We take them at their word that they will give it their best shot.  That is why we seek to maintain target risk levels in portfolios, but upgrade quality throughout.

Success, however, means volatility by definition…and a higher level of inflation that itself will need to be addressed.  Failure is more concerning.  The Fed getting it perfect sounds like make-believe.

Will Skeean, CFA

Partner – Investment Management Team Chair