Who’s Afraid of Low, Low Yields? by James T. Tierney, Jr., AllianceBernstein
Falling yields on Treasuries are often seen as a signal of a weakening economy that could undermine stocks. We think there are other explanations that don’t threaten the outlook for equities.
Treasury prices were widely expected to fall in 2014 for a second straight year. Instead, bond prices rose this year and the 10-year Treasury now yields around 2.6%, down from approximately 3% at the end of 2013. For equity investors, the flight to safety in government bonds is usually seen as a bad omen.
Yet through May, US equity and fixed-income returns have been remarkably similar—both have gained around 4%. This is peculiar because their performances are often viewed as opposite reads on the economy: when bonds do well and yields fall, investors are generally more cautious and skeptical about economic growth. Rising stocks typically point to an expanding economy and robust earnings. So what’s going on this year?
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Economy Looks Resilient
Perhaps the economy isn’t the culprit. In the first quarter, US gross domestic product contracted by 1%, which appears to support the bond case. However, much of this weakness was caused by a brutal winter in the Northeast and Midwest. Economic activity recovered in April, and despite mixed numbers in May, we don’t think the US economy is slowing down or headed for another recession. Stronger employment reports, record high consumer net worth, rising consumer confidence, and solid auto and housing sales all support moderate growth, in our view.
If not the economy, why are bonds so strong? We think there are three factors that could be driving the US bond market: relative value, supply dynamics and asset allocation.
On the first point, some international context is helpful. While the yield on the 10-year US Treasury may seem very low at 2.6%, it still seems to offer more value than a German bond at 1.4% or a riskier Spanish bond at 2.6%. International money entering the US market could be driving this trend. According to Federal Reserve Board estimates, about 47% of all US government bonds are owned by foreign investors—who aren’t primarily motivated by monthly changes in US macroeconomic data. So, on the margin, this suggests that US institutional and retail investors, who only own about 35% of the total, may not be the primary determinant of prices (the remaining 18% of outstanding securities is held by the Fed).
Treasury Supply Seems Tight
Supply and demand could also be an issue. With the annual US budget deficit shrinking, the government is issuing less new paper each month. Spring tax payments and ongoing bond repurchases under the Fed’s quantitative easing policy also reduce supply. As a result, the US government may have been a net buyer in recent months. Meanwhile, after US stocks outperformed bonds by approximately 35% in 2013, almost $40 billion has flowed into US bond funds this year through May, according to data from the Investment Company Institute—in a market that has a dearth of supply.
The bottom line is that from our perspective as equity investors, the US economy doesn’t seem to be driving the bond market. There are other significant, non-fundamental trends at play that could be supporting higher prices and lower yields.
Can Earnings Continue to Grow?
Meanwhile, when we compare earnings yields to bond yields, stocks look very attractive (Display). Of course, further equity gains must be driven by earnings growth after a stronger-than-expected first quarter. We’re encouraged by recent retail spending reports—especially comparable sales for several companies in May.
If consumer spending continues to improve through the summer, we believe US earnings should continue to beat market expectations and fuel the equity market. Since Treasuries don’t seem to be the most reliable economic forecasting tool at the moment, we think equity investors shouldn’t lose sleep over declining yields, while still remaining vigilant about the US economy and staying focused on earnings across the market and in individual holdings.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
James T. Tierney, Jr. is Head of Concentrated US Growth at AllianceBernstein Holding LP (NYSE:AB).