The economic outlook according to stocks and bonds: will it be rosy or will it be bleak?
With buoyant equity markets on the one hand and cautious bond markets on the other, Russell Investments' strategist Van Luu analyses which asset class is right, if any.
Asset class divergence
We have reached a point where equity and bond markets are diverging significantly. Global equity markets trade close to all-time highs while bond markets yields are continuing to fall. This divergent movement is unusual as both asset classes are pricing in very different views of the world.
Since the inauguration of US President Trump on the 20th January 2017, the MSCI World All Country index has risen by 5.8% suggesting that stock markets have an upbeat view of the world, spurred by optimism around tax cuts in the US and fading political risks (figure 1).¹
Figure 1: MSCI World All Country Index from Trump's inauguration
Figure 2: Falling 10-year US bond yields
Figure 3: Falling 10-year UK bond yields %
Which asset class is right – equities or bonds?
At Russell Investments, we believe that both markets are wrong to some degree. The near-term outlook for the US economy is currently the biggest debate in financial markets. This appears to be driving the optimism in global equity markets who, in our view, have become too optimistic about the growth prospects and overall outlook for the US. At the same time, we think that bonds markets are overly pre-occupied with falling commodity prices and high political risks coming out of Europe.
We always assess the outlook for markets through the lens of Cycle, Valuation and Sentiment (CVS):
The US Cycle
US economic growth was surprisingly weak in the first quarter of this year, coming in at an annualised rate of only 0.7%. The consensus view from the majority of economists is that we will see a pick-up in growth over the next few months.³ This view was re-iterated by the US Federal Reserve (Fed) in their recent hawkish commentary, stating that they still expect the economy to “expand at a moderate pace”. We, however, beg to differ.
Our US Strategist Paul Eitelman is significantly more cautious than other commentators and predicts that the US economy will remain soft for some time. Paul thinks that we will see disappointing corporate profit results and weak credit impulse figures (i.e. net new lending as a % of GDP) as we head towards the end of the year. Moreover, if the Fed continues to tighten into a soft economy, we may see further profit weakness particularly given that the unemployment rate is below the 4.5% threshold.?
Our restrained outlook for US growth and earnings contrasts with a constructive view on other regions, particularly Europe, where cyclical indicators continue to come in very strongly.
Government bond markets appear to have a much more cautious economic outlook than equity markets. Futures prices for the US key policy rate only imply a little more than one rate hike by the Fed this year and for the policy rate to peak at 2.5%, a much lower level than in previous cycles. German and US government bonds have been well bid as safe havens during uncertain political times. While we have some sympathy for the global bond markets' cautious view, the low level of long-term bond yields leaves little room for error. If inflation turns out a little higher than expected or political risk fades, government bond yields may rise noticeably.
Valuation of US equities and bonds
Valuations are not a good short-term timing indicator, but they are useful for shedding light on the long-term reward-to-risk ratio, which we think is clearly unfavourable for US stocks.
We see a valuation divergence between US equities and the rest of the world. Many valuation indicators are suggesting that the US stock market is very expensive at present. For example, Robert Shiller’s current cyclically-adjusted price-earnings ratio (CAPE) for US equities is the highest it has been for 15 years (see figure 4).? Other regions are not necessarily cheap, but are offering valuations around their historical averages.
Figure 4: Schiller PE (CAPE) Plot 1880 - present
CAPE PE: Cyclically adjusted price-to-earnings ratio
Bonds would seem fully priced as well, with long-term bond yields hovering near their historical lows as we saw in figures 2 and 3.
Our analysis suggests that equity markets around the world have become “overbought”, i.e. that the rally is stretched and a reversal is becoming more likely. Optimism in the US is a tide that has lifted all boats. We think a downward correction in world stock markets is overdue. Once a sizeable correction takes place, we would still like to buy the dip, but this will depend on the recession risks remaining low.
Government bonds would normally benefit from falling stock markets, but as bonds have already discounted a bleaker world view, the potential to rally is somewhat more limited.
One recommendation clearly comes out of our Cycle-Valuation-Sentiment process: look outside of the US for investment opportunities in equities. We have strong conviction that US growth will disappoint the lofty expectations. We like the cycle for European stocks and have become more positive on emerging markets now that the top down risks from Fed tightening and a rising US dollar look less worrying.
Our wariness with regard to US stocks does not mean we are excited about so called ‘safe-haven’ government bonds. High-quality Treasuries have become more expensive and are already pricing a more tepid economic environment.
In a market where both equities and bonds seem fully valued, it is also important to be patient and sit in cash until better investment opportunities emerge.
1 As of 22 May 2017. Source: Thomson Reuters Datastream. – data for charts from Bloomberg
2 As of 22 May 2017. Source: Thomson Reuters Datastream. – data for charts from Bloomberg
3 Peter Oppenheimer of Goldman Sachs - Unemployment rate is at 4.4% as of April 2017. Source: Bureau of Labor Statistics.
- As of 7 April 2017, when the Shiller P/E was at 29.19 since April 2002. Source: Robert Shiller’s website.