US markets were all in the red overnight. Aussie stocks are set to follow, too, with ASX 200 futures indicating a 41-point retreat.
While US stocks are potentially topping out, Aussie equities look like they are consolidating, after breaking out to multi-year highs. However, we’re increasingly looking like the odd man out.
That’s because the message coming from global bond markets is a worrying one, as the Wall Street Journal reports:
‘Government bond yields around the world plumbed new multiyear lows Tuesday, a sign of growing investor worries that global economic growth is poised to weaken.
‘The yield on the benchmark 10-year U.S. Treasury note, a key reference rate that helps set borrowing costs for everything from student loans to mortgages, traded at a recent 2.273%, according to Tradeweb, on track to settle at a fresh 19-month low. The yield on the 10-year German bund touched its lowest level since July 2016. Yields fall as bond prices rise.’
The global bond market is worried about a recession. US stock markets are worried, too. Overnight, the Dow Jones Industrials fell around 240 points. As you can see in the chart below, it’s very close to trading at multi-month lows:
This is not a big deal in the scheme of things. But given the ‘triple-top’ chart pattern that has potentially formed, things could turn ugly pretty quickly for US stocks.
Which makes the recent performance of the Aussie market even more surprising. As you can see in the next chart, the ASX 200 looks very bullish, having broken out to a new high last week, extending the bull market that has been underway since early 2016:
Is this a genuinely bullish sign? Or is this a bull trap, and one that will be reversed in the coming weeks as global markets become more bearish?
Ahhh, they don’t make it easy for you, do they?
What the bond market is telling you
Putting my rational investor hat on, I’d say buying the market here is highly risky. The bond market is telling you that a global economic slowdown is coming. The bond market is much larger than the stock market and, in my view at least, has a lot more informational content than the stock market.
When these markets diverge, I tend to believe the message coming from the bond market. It’s more truthful. The equity market is often tells lies.
And the bond market has diverged widely from stocks in the past few months. The chart below shows the Dow Jones index (in green) and the US 10-year Treasury Bond yield (in blue). These markets broadly tracked each other until the start of the year.
In 2018, a rising stock market and rising yields indicted a strengthening economy that would require higher interest rates to contain inflation. Then came the realisation that higher interest rates would quickly kill the expansion. Bond yields and the stock market both fell sharply.
Then came the early year rebound. But by January, the bond market wasn’t buying the ‘worst is over’ narrative coming from the stock market. Yields started to head lower while stocks continued to climb.
Stocks are not expensive relative to bonds
The reason for this is twofold. The Fed’s about turn on interest rates, unleashing a torrent of liquidity. Note: The Fed doesn’t have to cut rates to create liquidity. They just have to change expectations. The expectation was that no rate cut would be good for equities.
The other reason is a simple relative valuation argument. When bond yields fall, bond prices rise. Bonds yielding 2.3% versus a market on an earnings yield of 6.25% (equivalent to a price-to-earnings multiple of 16), tells you that stocks are not expensive relative to bonds.
And for large asset managers, this is the only equation that counts.
Of course, this ignores the fact that falling bond yields equate to a slowing economy that will soon enough hit company earnings. If company earnings fall then the market’s ‘earnings yield’ will fall, too.
This is what I think US equity markets may be starting to realise. The peak for stocks (so far, at least) came in April. Now, stocks appear to be listening to what the bond market is saying. They’re not entirely convinced, but they are certainly warming to the bond market’s story.
For the Aussie stock market, it’s a different matter entirely. Its surge is the result of an unlikely election victory and the expectation of an interest rate hit. That removes the risk of house prices continuing to fall, which is certainly good news for the economy.
But aside from the benefit of a short-term hit, is a reduction in interest rates really what our economy needs right now? Even Australia’s most prominent banker doesn’t think so, and that’s saying something. From The Australian:
‘Commonwealth Bank chief Matt Comyn says lower taxes and policies that promote consumer spending provide more economic stimulus than interest rate cuts…
‘He argued the government’s tax cuts would be a driving force in getting the economy moving — equivalent to two 25 basis point official rate cuts.
‘“It (a rate cut) has an effect but there are, of course, other things which I think are higher impact.
‘“Clearly some of the fiscal stimulus, cuts to taxes and increases in sentiment, they tend to have a much better transmission effect in terms of the broader economy.”’
As I said, if a banker is saying that, you really have to wonder what the RBA are doing cutting rates now…
Editor, The Rum Rebellion
Ed Note: Just a reminder that the latest Rum Rebellion market update is available on the Rum Rebellion YouTube channel. This week’s update focuses on the precious metals market.