1. The Great Divide

What we don’t know about investments could fill an encyclopedia, but the current positions of the stock and bond markets are difficult to reconcile.

Last week, the S&P 500 closed at a record high level. After a sell-off in May, investors in equities and corporate debt regained their confidence, thanks to hints of cooling tensions between the U.S. and China and the prospect of interest rate cuts by the Federal Reserve.

Government bond markets, however, did not find cheer. Interest rates across maturities were little changed, and the inversion of 3-month and 10-year U.S. Treasury yields has persisted. Nervous investors may prefer the stability of bonds to the risks of equities, at any price, and $12 trillion of sovereign securities now pay negative interest rates.

Weekly Commentary 6/28/19 - Chart 1

Therein lies the puzzle: How can equity markets stay bullish when bond markets are sending recession signals?

Some will point to dovish signals from central banks as supportive of stocks. But monetary easing in the United States is not expected to be substantial, and will take time to reach full effect. In markets like the eurozone and Japan, rates are already negative and unlikely to decline further.

It is difficult to think that corporate earnings will remain untouched by trade conflicts. Tariffs are often absorbed in profit margins, and supply chains are expensive to alter. Companies and industries targeted by trade retaliation will face unique challenges. Roughly 45% of sales for S&P 500 companies come from outside the United States; growth in several regions is showing clear signs of strain from ongoing trade frictions.

Some say fixed income markets are giving heavier weight to risk cases, which may be true. But it is unclear why equity markets would not show the same respect for possible downsides.

It is unusual to see stock and bond prices so strong simultaneously. It will be interesting to see whether the seemingly conflicting signals coming from the two markets will be reconciled in the second half of the year.