Strange Times, What Happens Next?

Frequently in the financial news, market pundits will opine on what the markets should be. Currently they are saying the stock market is over-valued and should be lower, and the bond market yields are too low and should be higher. I have found throughout my career that when there is consensus about what “should” happen, it rarely plays out that way.

One of the fascinating aspects of following the financial markets is trying to understand what the market is telling us now, rather than what it should or shouldn’t be. Both the stock market and bond market reflect what investors are expecting for the future, but the markets are not always aligned.

Right now, the stock market has been going up, which implies that we have economic growth ahead. However, yields are down in the bond market, which implies that growth is scarce and inflation is not a threat.

An alternative view of the low-yield bond market is that many investors are highly risk-adverse so they have crowded into the safe assets of the bond market, which pushes down yields. But the stock market is up, so are investors really fleeing to safe assets?

Strange times, indeed. What can we expect next?

Historically low yields in the bond market

Bond yields have never been this low. In some markets, such as Switzerland and Germany, yields are actually negative. Negative yields do not mean that investors pay interest to the debtor. It means that investors are buying bonds at a higher price than they will get back in interest and principal. There can be only two reasons for doing that. First, if an investor, such as a bank or insurance company, is required by regulators to own a specific amount of bonds and they don’t have a choice. The second reason is if the investor is expecting other assets to have a greater negative return and they are trying to avoid even bigger losses.

Why is there so much pessimism that investors would accept losses or flat returns? It is not just the covid-19 pandemic, because negative yields and near-zero interest rates existed before the pandemic started. Japan has had interest rates bouncing around zero for several years.

Since Japan has had very low interest rates for longer than either the US or Europe, there are lessons that we can learn from the Japanese markets to better understand our own.

Why have yields been so low in Japan for so long?

Economic theory teaches us that interest rates are low when there is little threat of inflation. Japan has had low inflation and sometimes has even had deflation (a decline in prices), which is consistent with low interest rates.

Economic theory also teaches us that when governments, businesses and consumers borrow a lot, that inflation will increase and interest rates will rise.

In Japan, government debt has increased substantially for years but interest rates and inflation haven’t risen. This disconnect has best been explained by the economist, Richard Koo. In his book, "The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession", he identifies different types of recessions.  It is key that different types are identified because effective policy responses will vary depending on what caused the recession.

Most of the recessions that occurred following World War II were the result of excessive demand that pushed up prices, which caused inflation. Over time inflation would lead to higher interest rates which would then dampen demand. Lower demand then caused yields to fall. Those lower interest rates eventually acted as a stimulus to demand and the cycle would start again.

But Japan’s recession in 1990 was different than previous post-war recessions. Since the 1990s in Japan, it didn’t matter how low interest rates fell, it didn’t stimulate demand. Dr. Koo identifies this situation as a balance sheet recession. Corporations and individuals held so much debt prior to that recession that their primary aim became paying down debt. They became so concerned about reducing debt that they slowed down spending. A lot.

The government started spending big to pick up the slack. With domestic companies and consumers spending less, government stepped in to fill the gap and it continues today.  Economic growth in Japan is very slow but still positive.  Despite the slow growth, unemployment is low too because of the decline in the working-age population.

Japan has shown that it is possible to have high levels of government debt and low inflation. If businesses and citizens don’t want to spend, you can’t make them do it.  Inflation will happen when government spending, corporate spending and consumer spending together compete for limited goods.  This is not happening, at least not yet. 

The Covid recession is obviously caused by a drop in demand, not from an overheated economy and not from sky-high debt levels.  However, similar to the 1990s Japanese recession, low interest rates are not enough to stimulate demand.  Governments are spending, but so far it isn't enough to compete with companies and consumers to create inflation.

Learning from low yields

If we step away from what we think yields should be and try to read what it implies for the future, it is reasonable to expect:

1. Dis-inflation (reduced inflation)
2. Maybe periods of deflation
3. Slow economic growth
4. Continued reach for yield by investors

The reach for yield is the scariest conclusion because it means that investors will keep adding risk to their portfolios and funding sub-par investments. But the alternative is to live with less investment income and that isn’t great either.

In this environment, it is important to keep an eye on cash flows on any investment you make. If it is a bond, how easily can the borrower pay it back? If it is a stock, how well is the company’s cash flow able to fund growth? If a company isn’t growing, it is going to be harder for the stock price to grow too. A declining stock price will easily wipe out any dividend benefit.

Do low bond yields hurt the stock market?

Comparing the US stock market and the Japanese stock market during the time of declining yields, both markets are up during this time period. The Japanese market has had lower growth and less price appreciation but the shape of the curve tracked similarly. It did take Japanese stocks longer to recover from the 2008 Financial Crisis than in the US.

Their market recovery didn’t start until 2012, while in the US it started in 2009.

Where are we headed?

Anyone who has been reading my blogs for a while knows that the long-term relationship is strong between S&P 500 price and earnings. Current earnings forecasts are for a recovery by 2022 and that appears to be what is priced in the market. The dividend yield on the index is 1.7%, well above the 10-year US Treasury bond. It does seem that investors have flocked to the stock market in anticipation of future earnings.

If you can tolerate the volatility of stocks and you have a time horizon greater than two years, the stock market still looks more attractive than sitting on cash at zero interest rates. It also looks better than long maturity bonds that don’t have a yield greater than the dividend yield. If your time horizon for your money is less than two years, you are better off accepting low bond yields for the foreseeable future--but please avoid the negative yields.

At Archer Bay Capital, we help clients better understand the markets and the economy so we can make better financial decisions together. Contact us to discuss stocks, bonds, and our forecast for economic growth, or to schedule a consultation today.