Considering the contentious political discourse taking place in our country and across the globe, it is remarkable how steady the investment markets have been. Bond yields have drifted lower this year, and stocks continue their measured climb.
The 10-year U.S. government bond began the year at 2.45 percent and rose to 2.6 percent in March, yet has dropped to 2.3 percent since. The stock market, as measured by the S&P 500 with dividends reinvested, has calmly risen nearly 18 percent over the past year.
The relative tranquility that has characterized markets over the past year is remarkable considering that, at this time last year, the country was deep in the throes of a contentious primary season with an uncertain election approaching. Still, the markets breezed through the elections without a hiccup.
Since then, investors have remained unflappable, even as the Fed raised interest rates three times since December. The bond market’s response to rising rates has astonished some pundits. The yield curve, a chart that plots the series of interest rates from short term to long term, has been flattening as short rates tick higher and long rates have fallen.
Observers point to benign inflation (1.4 percent in May), a 2 percent growth economy, and doubts surrounding the passage of President Trump’s agenda as reasons for the bond market’s behavior. Additionally, the low interest rates support the view that stocks are still attractive assets to own, even with the stock market trading at historical highs.
Consider that a risk-free, 10-year U.S. government bond with a 2.3 percent yield—all things being equal—is comparable to a stock with a price-to-earnings ratio of 43 (100/2.3). Though stocks are not risk-free assets, plenty of market observers view the S&P 500’s current PE of 24 as justified in this context. With earnings growth, analysts are forecasting a “forward” PE of 19 a year from now.
What could upset the apple cart? Were the yield curve to become “inverted”—meaning long-term rates were lower than short-term rates—that scenario would raise a red flag about Fed policy and the health of the economy. Or a spike in inflation would prompt the Fed to raise rates quicker, hurting both bond and stock prices.
The return of increased volatility in the bond and stock markets would likely cause investors to become more skittish. The simple math of the bond market in this low-rate environment means that even modest changes in interest rates cause significant changes in bond prices. As pointed out in The Wall Street Journal, the German 10-year bond jumped from a 0.25 percent yield to a 0.47 percent yield the last week of June. While a 0.22 percent increase in the yield doesn’t seem like much of a change in return to an investor, that rate increase caused the bond price to drop 2 percent and effectively wiped out eight years of interest payments.
The persistent low level of market volatility runs the risk of wooing investors into an attitude of complacency. However, it would be unwise to let down the guard. Markets can surprise at any time and, with both stocks and bonds trading at all-time highs, there is less of a “margin of safety” supporting asset prices.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or firstname.lastname@example.org.