It is a big three months for US markets as we approach the November Presidential elections. All eyes are on Trump vs Biden and the likely ramifications of each candidate’s success in the polls is widely debated. Both seem to share a view on big spending on green infrastructure and a continued war of words and policy action with China, however Biden seems a real threat to US healthcare stocks and the technology sector. Trump is still hoping a stock market recovery can help him come back from a deficit in current polling, however the global COVID-19 pandemic stands in his way.
Whilst a lot has been written about the global pandemic and its effect on the economy and the stock market, things feel different to the previous market falls at the time of the Great Financial Crisis. As a result, we are making sure we keep challenging ourselves on how we run clients’ portfolios as we are not convinced that what worked in previous times of market stress, can be successful again today. To explain this in more detail, we need to examine the bond markets.
The world’s longest bull market in U.S. Treasuries is now well into its fourth decade. The 10-year Treasury yield was 14% in 1984 and is now just half of one percent. For most of that time, dips in Treasury yields were a reliable indicator of economic weakness ahead. Today, that no longer seems to be the case. While there are certainly near-term market risks, including the pandemic, US elections and global trade tensions, there are also reasons to believe we are at the early stages of an economic recovery. Improving growth in manufacturing, the service sector and employment are validating that thesis, yet the Treasury market so far seems to be ignoring improving growth.
This has important ramifications for portfolio construction. First, long-term government bonds may no longer be the best option for yield or capital preservation with rates so low. Indeed, the “real” yield you stand to earn on a 10-year Treasury note is now negative one percent when inflation expectations of around 1.5% are factored in. Also, investors have grown accustomed to valuing equities based on their earnings potential relative to the yield on a Treasury. That method may not work as well going forward and could be fuelling some of the excessive valuations that we have seen more recently, especially in technology stocks.
The question we must ask ourselves is “why are yields so low if future expectations for the economy is not weighing them down?” Unprecedented fiscal and monetary stimulus is the answer. Simply put, massive amounts of liquidity from the Fed and other major central banks are being used to buy bonds to monetise all the newly created government debt and this action is likely helping to keep rates low.
This may sound like what happened during the financial crisis in 2008 and 2009, but then the Fed increased its balance sheet by $3.6 trillion over two and a half years. This year, they managed that in less than four months. Another key difference is that in 2008, banks held most of the new funds in reserves and consumers paid back debts, which kept growth low. Now banks are lending and consumers are saving, leading to the money supply increasing at a 24% annual rate. It is widely acknowledged that at some point the central banks are hoping for higher inflation to help to erode the huge levels of debt they are accumulating on their balance sheets. The effect of this bond buying, and central bank policy, would normally be a key driver for the kind of inflation pressures that central banks are hoping for and this should cause rates to rise.
Not this year, not so far. The Fed seems to be neutralising interest rate pressure by providing forward guidance much further into the future than usual. It has signalled it is willing to keep bond yields anchored near zero for years, not quarters. It is likely that this aggressive guidance will continue at important Fed meetings coming up later this month.
Action by the Fed has so far proven effective at relieving the pandemic’s worst potential economic damage and this same message has been repeated by major central banks around the world. That said, these policies can come at a cost. Valuations in growth stocks and technology stocks in particular are pretty high and we also need to be aware of higher than normal risk-taking in corporate credit markets, with a rapid appreciation of commodities like gold, and the depreciation of the U.S. dollar.
We remain aware of these risks to our clients’ portfolios, whilst grateful of the chance to pick-up long-term assets at attractive valuations today. There is the potential for longer term interest rates to move higher if inflation expectations continue to rise and we watch carefully for a potential dip in gold prices, which could signal that real yields are set to bottom. As always, there is much to consider, but also many opportunities.
I am now taking a break for a week or so, hence my update today rather than the usual Friday. I will write again in the first week of September, unless anything meaningful comes to light over that time. For now, enjoy what the rest of the summer has to offer, take care and should you have any queries, please do not hesitate to be in touch with the office.