Has a stock-market high ever been greeted with such indifference? The S&P 500 Index topped 1,900 last week while the FTSE 100 hit a 14-year record. Investors should be celebrating but in the main they’re looking nervously over their shoulders. What’s going on?
The first hint that something might not be quite right is the bond market. At the beginning of the year, pretty much everyone expected economic recovery and the associated tapering of the Federal Reserve’s monetary stimulus to send the yields on government bonds higher and their prices, which move in the opposite direction, lower.
Anyone who bet that way has paid a heavy price. US government bonds with many years to maturity (the most susceptible to movements in interest rates) have posted double-digit gains as their yields have plunged. The 30-year bond bull market has been granted yet another stay of execution. Rumours of a great rotation out of bonds into equities have been exaggerated.
The yield on the benchmark 10-year US Treasury bond, which started the year at around 3 per cent, has fallen below 2.5 per cent for the first time in nearly a year. In Germany, Bunds with the same maturity are yielding around 1.3 per cent.
More troubled than we hoped
For that to make sense, the economy must be more troubled than we hoped. It is certainly at odds with, for example, the recent growth in new jobs in the US or the record employment figures in the UK. It suggests that the UK bounce-back is an illusion and the recent slowdown in America is something more serious than just the result of a nasty cold winter.
That seems at odds with the headlines but it is certainly not out of line with what the top central bankers on both sides of the Atlantic are saying. In the past week or so we’ve heard the Fed’s Janet Yellen, the Bank of England’s Mark Carney and ECB’s Mario Draghi confirm that they are in no hurry to raise interest rates. Maybe bond investors have finally started to believe them.
The second hint of trouble ahead is the relative performance of the more cyclical and domestically focused small-cap stocks, which have been at the sweet spot of the market recovery since 2009, but which have recently underperform more defensive blue-chips.
Even as the S&P 500 was hitting a new high, the Russell index of the market’s relative small fry fell more than 10 per cent below its March peak, the generally recognised definition of a market correction. First emerging markets, then technology stocks, now smaller companies – the equity bull market has a worrying number of dissenters.
The key question
So the key question is whether bonds and smaller companies are telling us something significant about the recovery that wishful thinking refuses to let us believe just yet. As ever, Goldman Sachs makes the bullish case – yields were too high at the beginning of the year and they have simply come back down to an appropriate level given the growth outlook.
There are some other technical reasons why bond yields have fallen so far this year. One is the behaviour of risk-averse big investors who have taken advantage of the surge in their equity holdings last year to lock in some of their long-term liabilities, to pensioners for example, by buying long-dated bonds.
As for the small-cap underperformance, it is in part a consequence of a handful of over-hyped sectors such as technology and biotech having a wobble. Valuations among the market’s smaller companies rose sharply last year so they were always going to be vulnerable to deteriorating sentiment and increased risk aversion following Russia’s sabre-rattling in Ukraine.
Nervous summers
I have noted before about how much more uncertain investors have been this year than last. The lack of conviction in the equity market’s new highs and investors’ appetite for safer bonds suggests the recent pattern of nervous summers will continue.
No surprise against such a backdrop that fund managers are running their highest levels of cash in their portfolios since June 2012, the dark days of the eurozone crisis when Mario Draghi felt compelled to make his “whatever it takes” to save the euro speech.
With luck, markets will continue to climb the wall of worry but this is not the time to make bold calls.
