Misperceiving Risk and Pricing for Perception


July 7, 2017 [Yield, Growth, Inflation, economy]
Charles Roth

Low Treasury yields and high equity prices aren’t necessarily contradictory. Both suggest expectations of continued unexciting growth, low inflation and a steady Fed. What could go wrong?


Central banks are usually better at creating asset price bubbles than deflating them before they pop. While it is, of course, far easier to identify bubbles after they burst, the conventional cure for the ensuing economic fallout is the same that created the problem in the first place: monetary stimulus.

Investors know central bankers are loathe to prematurely withdraw stimulus before an ailing economy has reached “escape velocity.” If they do, as the European Central Bank did in 2011 to maintain an “impeccable” record on illusory inflation, they may well have to reverse course as the economy falls back into recession. Hence the ECB’s about-face late that same year, when it resumed slashing its benchmark refinancing rate as the euro zone economy slipped back into recession.

Now that the U.S. Federal Reserve is slowly reducing its extraordinary monetary stimulus nearly eight years after the financial crisis recession officially ended in 2009, many equity investors are increasingly talking about economic data in terms of what the indicators imply for the pace of benchmark interest rate hikes and the impact that pace could have on the aging bull market in stocks, if not bonds. “Good news is bad news, and bad news is good news,” they say, suggesting strong data will prompt the Fed to pull the trigger and hike its key rate a third time this year, while weak data will stay its hand.

The problem, as Thornburg’s Jeff Klingelhofer points out in this video is that the data often aren’t consistent, and aren’t always interpreted consistently by the market. Despite the recent uptick, Treasury yields are still quite low, while U.S. stock valuations remain lofty. The dissonance between low U.S. Treasury yields, suggesting the specter of a recession on the one hand, and on the other an equity market implying the long, albeit slow, economic expansion can continue into its ninth year, among the longest on record, is quite apparent and frequently noted.

Yet low yields and high equities can coexist and not necessarily be a ‘one is right the other wrong’ outcome, Klingelhofer points out. “To me, the best way to interpret low yields and high stock prices is that both sides are implying stable and unwavering growth expectations, as well as low inflation, keeping the Fed in play, but also in check.”

Low but stable inflation, unemployment on target, and the near full recovery in the housing market leave many investors on both the equity and fixed income sides feeling just fine about the Fed’s ability to gradually raise the benchmark rate and top it out near 3%. This “goldilocks” view is also supported by business and consumer sentiment surveys and notions that the U.S. consumer deleveraging cycle is coming to end, the 4.4% unemployment rate will soon support stagnant wage growth, and perhaps some reflation may still come out of Washington D.C. as deregulation proceeds even if tax reform and infrastructure spending appear more challenging than expected after last November’s election results. The complacency in this view is perhaps the biggest risk pervading the market today, Klingelhofer warns.

The sanguine perception of market conditions among both stock and bond markets tends to miss the flipside of many data points, and leaves little margin for error. Yes, consumer debt loads have come down, but mainly thanks to mortgage defaults. In fact, consumers have been re-leveraging, with student, credit card and auto loans climbing precipitously in recent years, while real median household income is still slightly below the pre-crisis, 2007 level. As for the low unemployment rate, the labor force participation rate, at 62.8%, still remains at near four-decade lows; notwithstanding the steady retirement of baby boomers, it may not be as “healthy,” as Janet Yellen recently put it, as it appears.

How about the health of U.S. corporates? Well, debt levels are at all-time highs, and according to the St. Louis Fed, the 2016 recovery in after-tax corporate profits may already be petering out, as the chart below shows. Segments of the retail sector, most notably shopping malls, are being badly disrupted by online commerce, while auto sector sales have been downshifting sharply this year. And though housing has been a bright spot, the data aren’t uniformly positive, with pending home sales, building permits, and housing starts flat-lining or declining in recent months.


Corporate Profits After Tax 1/1/2013 - 1/1/2017

Source: U.S. Bureau of Economic Analysis


Significantly, productivity growth has been falling, declining to zero at the end of the first quarter from end-December’s 1.8% and last September’s 3.3%.

To be sure, we’re not suggesting a recession is imminent. But the economy may well not be as strong as frothy asset prices suggest. If, however, the Fed has its druthers and hikes again this year, and three more times in each of the next two years, as planned, the impact on sovereign and particularly corporate debt loads will be heavy. The amount of income dedicated to debt servicing will jump, and interest coverage ratios will fall as borrowing conditions tighten, creating a highly challenging situation for lower-quality issuers and smaller firms looking for financing.

Generally, betting on broad outcomes—the economy will continue to chug slowly along, or fall into recession—probably isn’t the best approach for most investors. Both equity and debt markets are currently pricing in a steady-as-she-goes outlook for the economy and monetary policy, leaving scant margin for error.

The more prudent approach seeks the best relative values among individual securities. Select risk and reward trade-offs and adequate, if not ample, cash positions help with both managing inevitable market dislocations and capitalizing on them. For long-term investors looking for a less volatile ride and potentially better returns, risk is worth taking when it’s sufficiently compensated, whether central banks are trying to reflate downed economies or deflate asset bubbles that may ultimately trip them up again.

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