Treasury yields below zero on an inflation-adjusted basis for only the second time since Dwight D. Eisenhower's presidency have split Wall Street's biggest firms, underscoring the relative-value dilemma equity investors face following the biggest first-quarter rally in 14 years.
For Goldman Sachs Group Inc. (GS)'s Peter Oppenheimer, U.S. stocks offer a once-in-a-generation buying opportunity after yields on 10-year Treasuries fell to about minus 0.3 percent when the rate of inflation is deducted. Morgan Stanley's Adam Parker advises caution, saying Federal Reserve stimulus that has led the fixed-income rally can't last forever.
Last month's jobs growth, which was lower than estimated by any economist in a Bloomberg survey, underscored the economy's reliance on the Fed's help since the financial crisis began in 2007. At the same time, record-low yields on Treasuries are driving investors to riskier assets such as stocks, said Howard Ward at Gamco Investors Inc. in Rye, New York.
“Capital will chase returns,” Ward, who helps oversee $35 billion, said in an April 11 phone interview. “There's a tremendous shortage of investment income and there are fewer places to go to generate that,” he said. “Stocks are to a large extent the only game in town for earning a respectable return.”
Ward favors technology companies such as Apple Inc., Qualcomm Inc. (QCOM) and Microsoft Corp. given their earnings potential, as well as consumer stocks with emerging-market operations like Starbucks Corp. and Nike Inc.
Equities fell last week, driving the Standard & Poor's 500 Index down 2 percent to 1,370.26 in its first back-to-back decline since November, after the government reported that American employers added 120,000 jobs in March, fewer than estimated by the 79 economists in the Bloomberg survey.
The index has declined 3.4 percent from its four-year high on April 2, trimming gains of as much as 29 percent in the past six months, after the Fed said it won't add more stimulus unless the economy falters or inflation tops its 2 percent target. Futures on the S&P 500 rose less than 0.1 percent to 1,365.7 at 8:25 a.m. in London today.
The central bank already bought $2.3 trillion of bonds in two rounds of asset purchases and started a $400 billion program known as Operation Twist to replace short-term debt in its holdings with longer-term securities. Yields (USGG10YR) on 10-year Treasury notes fell below 2 percent last week after reaching a five-month high of 2.40 percent in March.
Consumer Prices Gain
Consumer prices excluding food and energy rose at a 2.3 percent annual rate last month, the government said April 13. Yields on 10-year Treasuries ended the week at 1.98 percent.
Benchmark 10-year Treasuries have yielded less than zero on an inflation-adjusted basis at the end of every month since November as concern Europe's debt crisis would derail the global economic recovery pushed investors to the safety of government debt. U.S. bonds returned 9.61 percent since Dec. 31, 2010, according to Bank of America Merrill Lynch indexes. The S&P 500 added 12 percent, including dividends.
With bonds so expensive, prospects for stock returns are “as good as they have been in a generation,” Oppenheimer, Goldman Sachs's London-based chief global equity strategist, wrote in a March 21 report. Share prices are too low given the economic outlook, he said. Oppenheimer recommends shares of global energy companies, Japanese industrial stocks, and U.S. technology corporations, according to an April 10 note.
Equities are close to the cheapest level ever relative to debt even after the S&P 500's biggest first-quarter rally since 1998, according to the so-called Fed model, which compares the earnings yield for stocks with Treasury rates.
Profit for S&P 500 companies have represented 7.16 percent of the index's price on average in 2012, or 5.13 percentage points more than yields on 10-year Treasuries, according to Fed model data compiled by Bloomberg. That compares with the average difference of 0.03 percentage points and the record high of 6.99 points when the bull market started in March 2009, according to data compiled by Bloomberg going back to 1962.
“This is a very attractive time for equities, especially relative to bonds,” Abby Joseph Cohen, the senior U.S. investment strategist at Goldman Sachs, said in a telephone interview on April 13. After three decades of declines, “it's hard to see how interest rates are going to go down much more and stay there for a long period of time,” she said.
Cohen said she likes stocks with increasing dividends in groups such as technology. David Kostin, the firm's chief U.S. equity strategist, recommends energy and technology companies.
Warren Buffett, the chairman of Berkshire Hathaway Inc. and the third-richest person in the Bloomberg Billionaires Index, said in February that low interest rates and inflation have made bonds “among the most dangerous of assets.”
The last time real yields were negative was from 1979 to 1980 when Fed Chairman Paul Volcker fought runaway inflation by raising borrowing costs. The same acceleration in consumer prices that Volcker targeted also pushed 10-year Treasury yields below the so-called core inflation rate at the end of 1970 and during 1974 to 1975. American consumer prices excluding food and energy rose 13.3 percent in May 1980, 310 basis points, or 3.1 percentage points, more than bonds.
During Eisenhower's presidency, real yields were negative in 1958, according to the International Monetary Fund.
Fed Chairman Ben S. Bernanke has left the benchmark rate near zero since 2008 to spur inflation and lure investors into riskier assets as he tries to help restore the 8.7 million jobs lost during the recession that ended in 2009.
Bad for Stocks
“If you're looking at real yields being zero, what that implies is the market doesn't expect a whole lot of real economic growth,” Wayne Lin, a money manager at Baltimore-based Legg Mason Inc., said in a phone interview on April 12. His firm oversaw $643 billion as of March 31. “It's negative for equities. Multiple expansion, earnings growth, all that is driven by economic growth.”
Morgan Stanley (MS)'s Parker said the economy has yet to prove it can grow without the Fed's help, posing a risk to equities. The central bank's attempt to eliminate the threat of deflation with unprecedented stimulus won't boost the stock market forever, according to Parker, the New York-based U.S. equity strategist at the firm.
Fed Bond Purchases
Managers at Pacific Investment Management Co., DoubleLine Capital LP and Loomis Sayles & Co., which collectively oversee about $1.5 trillion, expect a third round of Fed bond purchases as signs of economic strength fade and Europe's sovereign-debt crisis worsens. Gross domestic product will expand 2.3 percent this year, down from 3 percent in 2010, according to economist estimates compiled by Bloomberg.
“When rates are extremely low or extremely high, it's usually because policy has been enacted to combat crises,” Parker said in a telephone interview on April 10. “Equities work when real rates are in some healthy band like 3 to 5 percent. That's when you should be bullish. If you have extremely low or high real rates, it's usually a systemic problem that takes a long time to fix.”
Parker and Lin favor companies that pay high dividends. The S&P 500's dividend yield has averaged 2.01 percent in 2012, about the same as rates on 10-year Treasuries. Bonds usually have the advantage, offering yields more than two times higher on average since 1971, data compiled by Bloomberg show.
While telephone and utilities stocks have historically offered higher payouts, consumer companies from Gannett Co. (GCI) to Leggett & Platt Inc. (LEG) are among the top 25 S&P 500 companies ranked by yield, data compiled by Bloomberg show.
Gannett, the owner of newspapers including USA Today, raised its quarterly payout this year to 20 cents a share from 8 cents, lifting the McLean, Virginia-based company's yield to 5.33 percent. The stock has risen 67 percent since Oct. 3 including dividends, compared with a gain of 0.03 percent for Treasuries, data compiled by Bloomberg and Bank of America Corp. show.
Leggett & Platt, the Carthage, Missouri-based maker of bedding and chair components, is yielding double its average since 1980, data compiled by Bloomberg show. The stock has returned 23 percent since Oct. 3, including dividends.
Shares rallied on April 12 after Fed Vice Chairman Janet Yellen and New York Fed President William C. Dudley endorsed the view that borrowing costs will stay low through 2014. It's “still too soon to conclude that we are out of the woods,” Dudley said on April 12 at Syracuse University.
While the economy is still recovering, stocks are attractive, according to Byron Wien, the New York-based vice chairman of the advisory services unit at Blackstone Group LP, the world's biggest private-equity firm.
“The low interest rate environment is the attempt by the Fed to encourage faster growth and therefore lower unemployment,” Wien said in a phone interview on April 10. “The question is can the economy develop a natural momentum on its own, and that question is still open.”