From Greed to Fear
The 4 percent crash in the U.S. dollar in January didn’t harm the stock market, given that the S&P 500 rose 7.4 percent through January before the recent crash. Neither did the 0.45 percent rise in yields to 2.85 percent on the 10-year Treasury.
People thought those two factors would not hurt stocks.
Yes, the Fed is tightening, and the tax cuts will result in higher short-term deficits, both putting pressure on Treasury yields. Because the Fed’s balance sheet is made up of longer-dated Treasurys and mortgage-backed securities, a rise in yields hurts the value of its assets. And since the dollar is a liability of the Fed, a lower value of the asset side of the balance sheet means a lower value on the liability side.
On the other hand, the tax cuts boost growth and a lower dollar makes U.S. companies more competitive in international markets, at least in the short term, as competitive devaluations have seldom done any good to an economy long-term. So stocks had to go up.
However, in late January and early February and after a 10 percent crash in the S&P 500, we are seeing a change in the narrative.
“I don’t want to label what we’re seeing as a bubble. But I would say that asset valuations are generally elevated … for the stock market, the ratio of price to earnings … is near the high end of its historical range. If we look at, for example, commercial real estate and other assets, we’re seeing high valuations,” outgoing Fed chair Janet Yellen told “PBS NewsHour” on Feb. 2.
Yellen is right about stock valuations, but she misses the bigger picture.
Long before she became Fed chair, there was a paradigm that bonds and stocks would move in opposite directions because stocks were risky and bonds were safe. So if the economy did well, investors would buy stocks and sell bonds, and if there was risk on the horizon, they would sell stocks and buy bonds.
This was certainly true in the last financial crisis as stocks crashed and government bonds went up in price. However, since the central banks of the world started completely ruining markets with zero interest rate policies and quantitative easing, stocks, as well as bonds, moved up in tandem.
Bonds moved up because central banks around the world kept buying them, also incentivizing private investors to front-run their large orders. Stocks moved up to Janet Yellen’s historically high valuations because the risk-free interest rate is a key variable in any valuation model, be it discounted cash flow or discounted dividends.
Cash flow or earnings the companies would generate would be discounted by a lower interest rate, making these cash flows more valuable in the future and justify higher prices. Even though earnings yields and dividend yields are at historically low levels, they are still higher than bond yields. And with the economy doing fine, though not amazingly well, there was no reason to sell equities.
Recently with yields rising thanks to developed market central banks on a tightening spree, this narrative has flipped and the bad news is that bonds and stocks, as well as the dollar, can all go down together.
“So used are we to the relentless rise of the equity markets, seemingly without pause, this mini-tremor actually felt like an earthquake. But maybe this is the start of something more,” wrote Albert Edwards, the head of the investment bank Société Générale’s strategy team in a note to clients, and that was before the 4 percent crash in the S&P 500 on Feb. 5 and the 3 percent drop on Feb. 9.
Perhaps investors thought the Fed would not tighten as much in 2018 and 2019 and are shifting their stance.
“Investors were discounting only two 0.25 percent rate hikes in the United States during 2018 at the outset of the year. Now they are banking on three,” writes John Higgins of Capital Economics.
The firm believes that if both long-term interest rates, as well as stock valuations, revert to their long-term averages, equities could do worse than bonds.
“Valuations and profit margins are currently very stretched from a historical perspective. In a scenario where these variables had steadily reverted to their very long-run averages at the end of the ten-year period, the annual average real return on equities would be negative, to the tune of 2 percent to 3 percent [per year].”
Emerging Markets to the Rescue?
Treasury bond prices also came under pressure in January because there was a rumor China would invest less in U.S. government debt. Chinese officials denied the rumor, but it is clear that they have been buying fewer Treasurys over the past years.
However, even with China out of the picture, other emerging markets have been gobbling up developed-market debt at a record pace.
“Emerging markets have accumulated a massive $6 trillion of global fixed income assets and are a key financing source of more than 70 percent of new flow into U.S. Treasuries in 2017,” research firm Oxford Economics writes in a note to clients.
Emerging markets have been receiving inflows of risk capital from developed markets invested in their stock markets or privately through foreign direct investment. At the end of the buying and selling, the funds flow back into safer developed market fixed income securities — only this time they are owned by emerging market actors, private and official.
Oxford Economics thinks this trend will continue as long as the emerging markets receive funds from developed markets in a search for higher returns.
So if the world economy keeps on growing, and it’s business as usual, developed market tightening and a falling U.S. dollar could be cushioned by emerging market demand.
However, if the developed market central bank tightening keeps pushing developed market stocks lower and there is another credit crisis like in 2008, all bets are off for stocks and the dollar, and Treasuries could make a comeback again—but not one that you’ll enjoy seeing—just as they did on the mini Black Monday on Feb. 5
“The United States has now got double bubble trouble (bubbles in both corporate and household debt). Just like 2007, this is another economic boom fueled by an unsustainable credit bubble that will inevitably blow up with a rookie Fed chairman in place,” writes Edwards, who for this reason is more bullish on bonds.
Of course, in a risk-off scenario, emerging markets would sell off and the safe investments would move back into domestic hands, which is also good for bonds and the dollar. Both of them moved up as stocks imploded earlier this week but only the dollar could hold on to its gains.
“There would be a limited impact in the case of a flight from emerging market assets driven by increased global risk aversion. In this case, U.S. investors’ demand for safe fixed income securities would just replace riskier emerging markets investments,” writes Oxford Economics.