US stocks and bonds delay epic reckoning

Michael Mackenzie

Push by US stocks into fresh record territory reflects lower-for-longer interest rates Outlook

Bull market milestones always matter, especially when they arrive with a red flag.
Perennially optimistic investors may be heartened at the sight of the S&P 500 and Dow Jones Industrial Average entering uncharted territory this week.

But first, a little perspective. It has taken the S&P 14 months to reach a peak of 2,168. The nominal gain since the market ascended to 2,130 back in May 2015 is a paltry 1.7 per cent.

Including dividends, the performance improves to about 3.6 per cent.

A fresh market peak tends to signal one of two outcomes: the start of an extended breakout for prices such as investors enjoyed during 2013, or a topping-out process that ultimately defines the end of a bull run as seen in 2000 and 2007.

So what awaits US equities?

Usually a peak in equities reflects a combination of robust earnings growth, an improving macro outlook and excessive investor optimism over the ability of companies to grow their businesses.

At this juncture, we have a middling US economy expanding about 2 per cent, illustrated by a Federal Reserve unsure about the interest rate outlook. Enthusiasm for biotech and other fast-growing tech companies has distinctly cooled, while companies are on course to record their fifth straight quarterly year-over-year decline in earnings growth. Hardly the ingredients of a bull market.

Except these are not normal times; far from it.

If you are looking for an explanation as to why US equities are exploring record territory, much of the answer lies in the ever-shrinking yields on government debt.

In the wake of Brexit, the universe of negative-yielding debt has expanded further, while UK and US long-term bond benchmarks have plumbed all-time lows, with investors snapping up 30-year Treasury paper on Wednesday.

A dual rally in share and bond prices to record levels should not normally occur. Rising equity values signal optimism over the economy and earnings, contradicting the dour message sent by sinking yields.

The lower bond yields fall, so the attraction of securing some form of fixed return only intensifies. Declining yields boost the value of future cash flows for companies, and in an uncertain world, US blue-chips have a certain lustre that has not escaped the attention of investors.

Expanding equity multiples reflect how the market has become a proxy for yield seekers and, unsurprisingly, the big gainers among S&P sectors this year have been utilities and telecoms, which are packed with dividend payers.

A glance at a coterie of blue-chips, known as S&P Aristocrats — 50 US companies that have regularly increased payouts over the past 25 years — shows a total return of 14.5 per cent so far this year, more than double the broad market’s gain for 2016.

The distortions rendered by a world of negative and near-zero interest rates, along with central banks deploying quantitative easing policies, have dominated financial markets in recent years.

Periods of sliding bond yields are accompanied by robust buying of shares in dividend-paying companies. Indeed many companies have taken advantage of low borrowing costs to help fund shareholder-friendly activities of buybacks and increasing dividends.

That debt binge is now being followed by weakening earnings and a high multiple for the S&P — trading at forward 12-month P/E ratio of 16.6 versus a 10-year average of 14.3, according to FactSet.

Such a combination should temper bullish inclinations for US shares. However, set against that, there is a relief factor of Brexit jitters easing, Japan inching towards a fiscal stimulus package and no Fed tightening on the horizon.

The bottom line for investors is that both US equities and bonds — corporate bonds have not missed out on the sovereign rally — trade at expensive levels and face a reckoning of epic proportions at some juncture.

However, unlike Japan and Europe — where negative yields dominate and equity markets remain well under water for the year — the US remains an outlier, or what some traders are saying: “The only game in town.”

Plenty of juice remains in US bond yields that can be squeezed a lot lower from their present levels, helping drive equity prices higher.

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