Who's right? Bond or Equity Investors?
The two sets of investors are diverging after the Market rallied in July
August 3rd, 2022
The Market shrugged off a slow start to August to post an up day on the back of strong tech earnings. All major indexes rose for the day.
The S&P 500 gained +1.56%
The NASDAQ advanced by +2.59%
The DOW rose by 1.29%
The Russell 2000 climbed by 1.41%
The Market continues to reclaim some of its losses for the year as investors cheered on surprisingly solid earnings reports from tech companies like Paypal and Moderna. And today's performance builds on the Market’s surprising rally that started last month.
But do you buy it?
In July, the US stock market posted its best month since 2020. The Market reversed its downward trend, with the S&P 500 rallying 7%, while the NASDAQ surged 12%. Mega-sized technology companies, like Amazon and Apple, have led the way back up, ascending more than 15% from their year-to-date lows in June.
Why did the market rally? Good question, but there aren't really any good answers besides the less than satisfactory one of increasingly positive equity investor sentiment of where we're heading. Even with inflation at a 40-year high, an ongoing debate on whether we're in a recession, and monetary tightening, Wall Street is finding a way to stay optimistic despite interest rate hikes.
The Market rose this past month primarily due to two drivers of more positive sentiment. Corporate earnings are not as bad as expected, and some on Wall Street believe that the Federal Reserve could pivot its monetary policy to slow rate hikes.
On the corporate earnings front, investors are taking solace in that while earnings are lower than highs in December 2021, they are better than previously forecasted. Companies are managing their costs through layoffs and cutting investments.
On the monetary policy front, investors expected a severe move from the Fed after June's historic inflation number of 9.1%. But they were somewhat relieved when the Fed "only" increased interest rates by 0.75% (vs. 1.0%), a move that it previously signaled in June.
The “Not That Bad” Mentality
Wall Street interprets this restraint as an indication that the Federal Reserve will hold off on more aggressive policies, such as raising interest rates by a whole percentage. Combined with better than feared earnings, Wall Street is starting to peep a scenario in which the US economy can avoid a hard landing.
However, the central bank's move shouldn't be interpreted as softening. The Fed has made it extremely clear over the past few months that inflation is Public Enemy No.1. And low unemployment and stable consumption are providing the Fed with more wiggle room to tighten policy without inducing a full-scale downturn.
So, we're not out of the woods quite yet. By all measures, extreme times call for drastic measures, and we are currently in code Mountain Dew Code Red (not sponsored). The Fed's policies reflect that, no matter how pundits recalibrate their expectations.
For example, at the start of the year, many economists (including members of the Fed) believed that hikes would only go up in 0.25% increments. But we blew through that ceiling with a 0.5% increase in April and 0.75% in both June and July, hikes unfathomable just three months ago.
And the Market's reaction to "more moderate" increases has been fairly nonsensical. It's as if one sees a weather forecast for a drizzle 🌧 but is happy with a hurricane--out of relief that it's not a tsunami 🌊.
But what can we say? We're just human, and collective human thinking can be strange. Thus, transitively, the Market is also a strange place.
But despite July's stellar month, many financial market experts warn that the worst could be yet to come. And they point to the bond market as an actual gauge of where the economy could be heading.
Bond Investors Are Increasingly Bearish
Existing bond prices have dropped sharply this year due to rising interest rates. Reminder: When interest rates rise, the value of bonds in circulation decreases since investors want to buy the new bonds that pay higher interest.
For reference, GOVT, an ETF that tracks the prices of US Treasuries with maturity dates ranging from 1 year to 30 years, has declined by more than -7% this year, up from a low of -10.5% a month ago. And while bond yields are dropping across the board as investors snap up bonds out of fear of a recession, the yield curve is still inverted.
We've discussed the yield curve in the past. Remedially, it's a plot that looks at the relative yields of bonds with different maturity payment dates. And usually, bonds that have maturities nearer in the future (i.e., two years) have lower yields than those further out (i.e., five years). It makes sense—investors need to be compensated more for holding something for longer.
But since June, the Yield Curve has been inverted, meaning bond investors demand more from shorter-term treasuries. Why? Basically, it can be distilled down to investors thinking something bad will happen with the US economy within the next two years.
And by one measure, this sentiment has worsened since June. In looking at the difference between the yield of a 2-year Treasury Note and a 10-year Treasury Note, one can calculate how much more investors are demanding from shorter-term versus long-term government debt.
In mid-July, a 2-year required 0.28% more yield for investors to hold compared to a 10-year, which was the widest spread since 2000, the start of the DotCom stock bubble collapse. This difference has increased to 0.37% today, which indicates that bond investors are increasingly betting that the economy will enter a recession.
So we have two conflicting data points on where the economy is heading. In one corner, we have a stock market rally in which equity investors are relieved that Fed policy isn't accelerating. In the other corner, we have bond investors preparing for a recession.
So who's right? Hard to say. But generally, bond investors are a bit more rational in their outlooks. And while the stock market is heavily connected to the US economy, it is neither a surefire bellwether nor a reflection of the actual economy.
Stay Frosty,
Alex with TAI