Bonds Look Globally, Stocks Stay Local by Francis Gannon, The Royce Funds
The bond market’s ever-lower yields are a vote of little to no confidence for global growth yet U.S. stocks remain strong in the belief that our economy is sound. We make the case for stocks getting it right.
Opposing Signals from Stocks and Bonds
There is a very spirited, at times contentious, debate going on in the U.S. right now—but it has nothing to do with the upcoming election.
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We’re talking about the disconnect between the bond market and the stock market—each of which is sending what look like starkly contradictory signals regarding the state of the economy.
In the wake of Brexit, bond yields remain near record lows—and are now negative for 10-year notes in Germany and Japan.
Stocks, on the other hand, continue to show resilience and strength. The S&P 500 made a new high late in the first week of July while the Russell 2000 has gained more than 20% since hitting its year-to-date low on 2/11/16.
Making Sense Of the Conflicting Signs
So how do we make sense of this, in particular for small-cap investors? Perhaps unsurprisingly, our own vote is a cautiously optimistic one for equities.
First, while it’s true that the bond market’s record of predicting economic downturns has historically been good, we think the flattening yield curve means something different this time. Typically, the curve flattens because short-term rates and funding costs are rising, so long-term yields fall in expectation of a recession.
Today’s situation, however, could not be more different—short-term rates have not moved much while long-term rates are dropping precipitously. And lending has not tightened appreciably so far in 2016.
This suggests to us that long-term rates are falling more primarily because of global concerns about growth—consider, for example, how Janet Yellen’s comments now routinely discuss the Fed’s take on the global economy—than about imminent recession here in the U.S.
The U.S. Economy Keeps on Chugging Along
In fact, when we want to take the pulse of the economy, we rely most on the corporate management teams we talk to every day. What we’ve been hearing is an outlook that is far more cautious and uncertain than pessimistic. Well aware of the fragility of current conditions, they have also offered some measured optimism in terms of growth picking up, however gradually or in fits and starts.
In addition, they’ve noted to us how supply and demand seem to be coming closer to balancing in industries as diverse as steel, in-land barges, onshore oil services, and irrigation equipment.
Of course, these are highly uncertain times, and the U.S. economy is sending some mixed signals. On the one hand, it’s clear that the pace of growth in the U.S. economy remains slow, and there have been numerous signs, from manufacturing to hiring, that the business cycle is beginning to flatten. On the other, two leading indicators—housing and autos—remain strong.
So while global uncertainty creates the possibility of an even slower pace of growth, we do not see the contractions that define recession as likely.
Slow Growth + Low Returns = Good Times for Value
We think the current climate of uncertainty and mixed signals equates to a low return environment for stocks, which has actually been in place for more than a year.
We would therefore caution investors to think carefully about valuation and earnings. It appears to us that in their zeal to chase yield, which has meant good things for the share prices of utilities and REITs, too many investors have lost sight of the power of compounding, of looking for better businesses that are capable of not just surviving but thriving in a slow-growth economy.
In trying to avoid risk, investors in these defensive areas may have overpriced safety because valuations for many of these ‘safe’ stocks look quite rich to us—and thus carry increased risk.
In contrast, it seems clear to us that cyclicals as a group have the most attractive combination of valuation and earnings—and earnings are likely to matter more and more as economic growth continues at a slow—or slower—pace. And after lagging their defensive counterparts through 2015, most cyclicals are just beginning to catch up.
Going forward, we think that attributes such as valuations, earnings, and cash flow will continue to matter. We’ve seen a lot of this so far in 2016, when small-cap leadership has been squarely with value, and many cyclical areas are competing with defensives for sector and industry performance bragging rights.
As we have argued for some time, what we see as the laws of finance can only be suspended (or ignored) for so long. What we are seeing now is the gradual normalization of the equity markets. When interest rates begin to tick up again, we are likely to see the same for bonds.
We suspect that only a period of more historically typical behavior from both stocks and bonds will resolve the current conflict.