Trouble ahead? Stock and bond markets sending divergent signals

The bond market is screaming “halt,” while the stock market is scratching its head wondering what all the fuss is about.

For financial advisers, the challenge will be to figure out whether it makes more sense to trust the bond market’s signals that risks are mounting, or trust the newly disconnected world of stocks seemingly defying gravity and historical market norms.

Bill Northey, chief investment officer at the U.S. Bank Private Wealth Group, downplayed the falling yield on Treasury bonds, now at 1.36%, as a global reaction to the
historic Brexit vote, combined with the fact that so much of the world is now offering negative real rates on sovereign bonds.
“Clearly, since the vote in the U.K. there has been a bit of a capital market dislocation,” he said. “Traditionally, with yields low, it would indicate a more dire circumstance than we actually find ourselves in.”

Even though Mr. Northey said he has pushed his forecast for the Federal Reserve’s next interest rate hike out from this summer to late in the fourth quarter, he doesn’t believe the dislocation between stocks and bonds is reason for alarm.

“It is not entirely unprecedented, but it is unusual,” he said. “Whether you look at economic growth or earnings growth, the economic backdrop is somewhat disconnected with the situation we find ourselves in.”

It is true that with approximately $13 trillion worth of global bonds now yielding negative real rates of return, the U.S. Treasury bond’s meager yield is appealing to global investors. But the bond market is generally considered smarter than the equity market, and the bond market is signaling caution.

“There’s starting to really be a profound divergence between the signals from the stock and bond markets, and somebody has to be wrong,” said Bob Rice, chief investment strategist at Tangent Capital. “If you just take what negative and super-low rates tell you, combined with slow growth and no inflation, that’s not great news for equities,” he added.

While stocks pulled back slightly on Tuesday, market watchers were mostly perplexed by the rebound last week that followed the extreme pullback in the wake of the Brexit vote.

The basic takeaway is that investors have piled into Treasuries, a traditional risk-off move, while equities remain stubbornly expensive, even if they have been flat over the past few years.

As Mr. Rice pointed out, the valuations for equities suggest a reversion to the mean is inevitable.
“This is certainly not great news,” he said. “It doesn’t mean there’s going to be a crash, but it certainly means there’s limited upside and meaningful downside.”

Doug Cote, chief investment strategist at Voya Financial, also justifies the shrinking Treasury bond yields as one of the few places around the globe with positive yields. But he also worries that equity investors have become too complacent.

“The sustainability of this bull market is dependent on second-quarter earnings, and this could be the fifth consecutive quarter of negative corporate earnings, which is something that hasn’t happened since 2008,” he said. “This is not good.”

Mr. Cote, like Mr. Rice, believes there needs to be a stronger effort toward both fiscal and monetary policy. But equity investors continue to lap up the environment of historic low-interest rates, which just paints the Fed into a tighter corner.

“Everybody should want rates higher, because it’s a sign that the global economy is healing,” Mr. Cote said. “People are bidding up equities because bond yields keep going lower and lower. But the S&P 500 is a multinational index, and it is the canary in coal mine for international growth.”

Mr. Rice took an even harder swipe at both the Fed’s monetary policy and the politicians in charge of fiscal policy.

“You really do wonder what the catalyst will be for some changes,” he said. “The only thing I can think of is the government needs to put some real fiscal policies in place, because monetary policies alone cannot fix this fiscal problem. We’ve got to start getting fiscal policy to line up with monetary policy.
These politicians can’t get away with sitting on their hands and thinking the central bankers are going to solve all the problems.”