Sticking With Stocks

Bonds and Stocks Both Rally

Last week was marked by gains for both stocks and bonds. Bond yields fell to an 11-month low, with the yield on the 10-year U.S. Treasury hitting 2.44% as prices correspondingly rose. A similar trend was evident outside the U.S., with German 10-year Bund yields trading at below 1.30%, the lowest level in a year. Meanwhile, stocks also advanced, with the Dow Jones Industrial Average up 1% for the week to 16,717. The S&P 500 Index climbed 1.49% to 1,923, while the tech-heavy Nasdaq Composite Index rose 2.25% to 4,242.

Broadly speaking, both stocks and bonds are looking expensive. But at current levels, traditional bonds in particular offer little value. We don’t expect a big selloff in bonds, causing rates to sharply climb back up, but overall, we continue to favor equities over bonds, even as stocks continue to move toward new highs.

What’s Driving the Bond Rally

Bond markets continue to defy expectations and investor appetite for bonds remains undiminished, despite media reports to the contrary. Indeed, last week saw another $6.3 billion flow into U.S. bond funds, with $1.2 billion into fixed income exchange traded products.

Although economic data continues to be mixed—for example, last week revealed the U.S. economy actually contracted by 1% in the first quarter versus an initial estimate of 0.5% growth—the demand for bonds and subsequent drop in yields appears to be driven by technical factors, rather than any serious re-evaluation of the economy.

Perhaps most importantly, institutional buying of bonds appears to be particularly strong, as many U.S. pension plans look to “de-risk” (sell stocks and buy bonds). In addition, U.S. commercial banks are increasing their bond holdings. In the first quarter of the year, the collective holdings of U.S. Treasury securities by banks increased by 23%, the biggest shift since the financial crisis.

Still, while the drop in yields has been both dramatic and unexpected, there are two caveats. First, the rally in U.S. Treasuries is occurring in the context of very light volume, which helps push up prices. Second, investor demand may be starting to moderate. Last week’s auctions of two- and five-year Treasury notes were characterized by somewhat mediocre demand. 

We still expect interest rates to rise modestly in the second half of the year, although we don’t foresee a dramatic “melt-up” in rates. But even a small rate rise puts bond holders at risk, and at these prices, we don’t think traditional taxable bonds, notably Treasuries, offer enough value to compensate investors for those risks.

Looking for (Relative) Value

Rather than chase yields lower, we’d continue to favor stocks. That said, investors do need to recognize that equity markets are also getting more expensive, with the rally in stocks pushing valuations toward the upper end of their historical range. Valuations for both the S&P 500 Index and the MSCI World ex-U.S.A Index of developed markets are now trading at four-year highs. Stocks are beginning to look expensive in an absolute sense, although they still look cheaper than bonds.

However, there are two big exceptions to this stock story: Japan and emerging markets (EMs). Of the major developed markets, Japan—which has actually underperformed Russia year-to-date—is by far the cheapest. Currently, Japanese equities are trading at just 1.17x book value, a 56% discount to U.S. stocks and a 43% discount versus a broader measure of developed markets. Japan typically trades at a lower valuation—due to relative low profitability—but the current discount looks large.

For their part, EMs also look reasonably priced, trading at a discount to their post- crisis and long-term averages. While not particularly cheap on an absolute basis, EM equities still appear inexpensive relative to their developed market counterparts.

In short, in a world of few bargains, investors need to tread carefully and look for relative value. Within equities, Japan and EM offer that sort of relative value, and for the same reason, we still prefer stocks over bonds.

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