It Has Been a Near-Perfect Investing Environment. But It May End Soon.
January 22 2018 - 12:06PM
Dow Jones News
By James Mackintosh
The perfect investment is one that only goes up. Almost as good
is an investment that does well when the rest of your portfolio
hits a rough patch, but over time still makes money.
Such a perfect investment shouldn't exist. Yet, for the past two
decades, government bonds have offered exactly this free insurance,
moving in the opposite direction of shares in the short run but
producing gains almost as good as equities in the long run.
The scale of the magic is stunning: From the start of 2000 to
the end of last year, holding the latest 10-year Treasury and
reinvesting coupons returned 155%, the S&P 500 with dividends
158%, while a 60-40 equity-bond portfolio beat both.
But the magic can't continue forever. If the link between equity
and bond prices were to return to what once counted as normal, the
magic disappears -- and there are good reasons to fear that could
happen soon.
The danger is that bond yields rise without any corresponding
strength in the real economy to protect profits and stock prices.
The two most obvious causes would be the return of inflation or a
shift of stance by the Federal Reserve to stop protecting investors
from losses.
Both of those possibilities are worth worrying about.
Start with how shares and bonds behave. Prices of the two
biggest asset classes have tended to move in opposite directions
since the late 1990s, measured as a strong negative
correlation.
This pattern is so well-established it seems like the natural
order of things. But since the start of the 19th century, there has
been only one other significant period where stocks and bonds
behaved this way, according to Ian Harnett of Absolute Strategy
Research. The late 1950s and early 1960s had a similar stock-bond
relationship to the past few years, and were also the last time
inflation was quiescent.
Caution on inflation
The stock-bond link is complex, but depends to a large extent on
inflation, uncertainty about inflation and more recently the
central bank.
When investors are confident that inflation is under control,
they focus instead on the real economy, and economic news pushes
bonds and equities in different directions. A strong economy
generally means bond yields rise (and so bond prices fall) in
anticipation of higher inflation and higher interest rates, while
share prices rise in anticipation of higher profits. When there are
fears of slowing growth, investors dump stocks and buy bonds.
Fear of inflation alone usually has the same upward effect on
bond yields (and so downward effect on bond prices) as economic
growth. But inflation doesn't help corporate profits much, while
higher yields mean a higher discount rate applied to future
profits, which -- in theory at least -- should push down stock
prices.
It's too soon to be sure that inflation is awake again after
lying dormant for a decade, but there are signs that the tight U.S.
jobs market is leading to higher wages. Technological advances such
as online shopping still weigh on prices, but with little spare
capacity, inflation should pick up. If investors switch focus from
the economy to inflation, the nightmare would be higher bond yields
and lower share prices.
Inflation itself isn't the only concern. Alongside low inflation
has come a belief that inflation has been conquered. The extra
yield on Treasurys that investors demand to compensate them for
inflation uncertainty, known as the term premium, is extremely low.
Inflation options are pricing the lowest chance of inflation being
badly behaved over the next five years -- that is, inflation being
above 3% or below 1% -- since at least 2009, according to
Minneapolis Fed calculations.
It's hard to see how investors could be much less concerned
about inflation, so the risk is that anxiety returns, bringing with
it higher bond yields and arriving with enough force to pummel
share prices.
Fed risk
The final risk is the Fed. Almost everyone thinks that the Fed's
multitrillion-dollar bond purchases succeeded in lowering yields
and pushing up stock prices. Quantitative easing has only just been
put into reverse, and the Fed's $4 trillion balance sheet ended
last year only $3 billion smaller than it started.
As the balance sheet shrinks this year, the effects the Fed had
on stocks and bonds should also go into reverse, creating upward
pressure on bond yields and downward pressure on stock prices.
Worse would be if the Fed's new leadership decided that
investors have had it too easy. The late-1990s switch in the
stock-bond relationship came as investors realized the Fed would
bail out the market with rate cuts in bad times, while letting the
good times roll. This asymmetric "Greenspan put" has continued, and
will probably become the "Powell put" when Jerome Powell takes over
this year. However, if Mr. Powell wanted to take a hawkish tone, he
could make clear that the Fed will no longer mollycoddle the
markets.
None of these dangers is sure to materialize in 2018. Inflation
can stay low for longer. The economy can improve even further. The
Fed can keep feeding its friends on Wall Street. Or correlations
might be overwhelmed by a new market mania; after all, the S&P
500 managed a near-20% gain in 2017 even as bond yields ended the
year where they began. But high on the list of things to worry
about is that higher bond yields will finally arrive in 2018, and
bring with them not even more new stock-market highs but a
correlation crisis.
Mr. Mackintosh writes The Wall Street Journal's Streetwise
column. Email james.mackintosh@wsj.com.
(END) Dow Jones Newswires
January 22, 2018 12:51 ET (17:51 GMT)
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