Bob Doll: Bond yields are due for a comeback

Low levels of market volatility, a pickup in M&A activity, a difficult revenue environment for banks and improving housing data all gather headlines, yet the bond market garners the most focus.
Since declining bond yields are often associated with weak economic growth and falling equity prices, many are wondering why yields are low and falling. There’s a long list of reasons, but we want to highlight five: First, investors are still engaged in a flight to quality in light of the geopolitical crisis in Ukraine. Second, weak European growth appears to be prompting the European Central Bank to consider aggressively easing monetary policy. Third, the shrinking U.S. budget deficit brings with it a smaller supply of Treasuries. Fourth, real economic growth and inflation have remained low. And fifth, it looks to us like many investors are abandoning short positions in Treasuries.
Other fixed-income signals, in contrast, are suggesting increased risk appetite and stronger growth. Corporate credit spreads are narrowing (meaning investors are still investing in higher-yielding bonds, which is usually a signal of more risk appetite). Also, the yield curve is steepening (typically a signal for stronger economic growth).

Weekly Top Themes

Real GDP contracted at a 1% annualized rate in the first quarter. The details in the report, however, actually appear favorable for second-quarter growth. Almost all of the downward revision was due to a decline in inventory accumulation, which should translate into a more rapid pace of production in the second quarter since businesses are now operating with less inventory overhang.
We expect second-quarter GDP growth of 4% or higher, and also forecast growth of more than 3% for the second half of the year.
With increasing consumer confidence and declining unemployment claims, we think the data will show that consumer spending accelerated in May.
Initial unemployment claims dropped to 300,000 last week. The four-week average for claims is at its lowest level since the expansion began, indicating improvement in the U.S. job market.
A close look at the stock market suggests this is still a stock-pickers’ environment. Although the S&P 500 is at an all-time high, some data does cause us to pause. There have been limited new daily highs, and equally weighted and small cap averages have not made new highs. Clearly, the rising tide is not lifting all boats, which to us means that a selective approach remains critical.

The Tug of War Between Equities and Bonds

Based on recent performance, stocks are suggesting that better economic times are ahead, while the bond market is telling a bleaker story. It seems either bond yields will need to rise or stock prices will need to fall. So which is it? We expect economic growth to accelerate and thus believe that bonds yields are more likely to rise than stock prices are to fall in the coming months.
But would rising rates derail the bull market? Not necessarily. If yields were to rise quickly and dramatically, that could unnerve investors and cause a downturn in equity prices. But we believe equity markets will be able to remain resilient if and when yields start to move higher, and we would only become concerned after yields have moved quite a bit higher than where they are today.
Robert C. Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management.