Stock investors forced to pause at yield signs
This is not the interest-rate scare we were promised.
Most market players for most of the year have been looking toward the approach of the first Federal Reserve rate boost since 2006.
Some felt it would signal the momentous end of an easy-money era, for good or ill. Plenty of Wall Street handicappers have insisted it would be no big deal, but most figured it would at least stir the markets’ anxieties as it arrived.
Instead, we’re witnessing two quite different rate scares: Another alarming, and mostly unexpected, drop in Treasury rates, and a grinding rise in yields on high-risk corporate bonds.
The 10-year Treasury yield (^TNX) has slid to just above 2% from 2.3% the day before the Fed elected to keep rates near zero three weeks ago.
Part of this drop could be the undoing of bearish bets that Treasuries would sell off and send yields higher on a Fed action. There was also some talk that China and other countries’ sovereign wealth funds were selling US government debt to bolster their reserves and defend their currencies. And, as ever, the unsettled stock and commodity markets are also chasing nervous investors back into Treasuries.
But it’s undeniable that this compression of rates has come amid yet another global economic soft patch that has not fully spared the U.S.
The Atlanta Fed’s real-time snapshot of U.S. GDP in the just-ended third quarter sank to 0.9% yesterday from 1.8% a few days earlier, largely on weak manufacturing and exports data. Economists are still looking for close to 2.5% growth, though those forecasts are being revised lower.
If the GDPNow model is close to correct, it would be the weakest third quarter and the first to fall short of at least 2% growth since 2011.
From an investor’s perspective, the sinking risk-free Treasury yield would seem to be flattering the attractiveness of stocks – at least cosmetically.
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The dividend yield on the S&P 500 (^GSPC) is now almost precisely equal to the 10-year Treasury’s. Stocks’ yield has typically been lower than bonds’ over the past half decade, though stocks did out-yield Treasuries near the 2009 bear market bottom and for stretches of 2011-2013 – all relatively good times to own equities.
But it’s far from certain that stocks are priced for a further slowdown in growth and profits, with the sense still out there that the Fed is seeking a chance to get rates away from zero and not deliver more stimulus.
The climb in high-yield corporate bond risk spreads has been a more direct challenge to stocks in recent weeks and months. Junk bonds are arguably the linchpin asset class of the bull market, where cheap money, corporate cash flows, the demand for scarce yield and risk appetites meet.
In some respects, equities have mostly tagged along with high-yield credit through this post-crisis period. Charles Schwab fixed-income strategist Kathy Jones noted this week that the 12-month trailing total return of high-yield bonds and the S&P Dividend Aristocrats (a group of big dividend-paying stocks tracked by the ETF under ticker NOBL) shadow one another closely and junk has led large-cap stocks return lower this year.
Even as the stock indexes have put a bit of distance between themselves and the August lows, junk yields have kept rising. This will pressure stock valuations as long as it lasts, though put another way, if the junk market firms up it would clear the way for greater relief in stocks.
Marty Fridson, the veteran junk-bond strategist at Lehmann Livian Fridson Advisors, has been calling the high yield market overvalued and vulnerable for a while now. In recent weeks, though, he’s said the market had finally weakened to the point of being fairly valued.
This doesn’t mean junk will rally and take stocks higher with them. But it could suggest that real-money buyers could see value and calm at least one of the unexpected rate scares weighing on the markets now.
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