It was a rough night over in the US last night.
Not only for stocks, but for bond investors too.
The 10-year US government bond yield fell a whopping 15 basis points to around 1.52%. Yields around the world are increasing as inflation expectations start to increase.
The stock market didn’t like it. The Dow fell 1.75%, the S&P 500 2.45% and the NASDAQ sank 3.5%.
Expensive stocks are very sensitive to higher bond yields. And tech stocks in general have been very expensive for some time. Take Tesla for example. It’s the most insane bubble I’ve seen in a long time.
And it’s now starting to pop. The stock is down sharply this week. Overnight, it broke through another level of support at US$700, down 8%. It was fun while it lasted, but I think the party is over for Tesla.
That’s not to suggest the whole market is going to collapse. It’s important at times like this not to let your inbuilt biases come out and dominate your thinking.
There are definitely pockets of overvaluation and extreme speculation in the market. These should be avoided.
But I don’t agree with the notion that the whole market is going to tank. Sure, it could correct 20% or so…but that is just standard stock market behaviour.
There are a few reasons for that.
Firstly, the concern about inflation is misplaced. Yes, bond yields are rising. But they are just heading back into what could be considered normal in a post-2008 context.
The chart below shows the 10-year US government bond yield roughly since the start of the last cyclical upswing in mid- to late-2016. Yields bottomed at 1.5% and rose to around 3.2% by late 2018.
Because of the amount of debt in the economy, it couldn’t sustain rising rates, and another downturn resulted.
This time around, how much more debt is the economy carrying?
I don’t know the answer to that, but it is in the trillions. Does anyone really think the economy can handle much higher rates before deflationary forces kick in?
Where is the point it screams ‘Uncle!’ this time?
2% on the US 10-year? 2.5%?
The point I’m making here is that it is a low probability outcome to think that yields will rise to 4–5% in an inflationary outburst and halve stock price valuations from here.
The more likely scenario is that yields rise towards 2% over the next few months and then the whole inflation euphoria fizzles out as the reality of a hugely indebted economy and a large output gap means rising price pressures won’t be sustained.
What is the ‘output gap’? The Brookings Institution explains…
‘The difference between the level of real GDP and potential GDP is known as the output gap. When the output gap is positive—when GDP is higher than potential—the economy is operating above its sustainable capacity and is likely to generate inflation. When GDP falls short of potential, the output gap is negative. Figure 2 shows that recessions such as the Great Recession of 2007-2009 and the COVID-19 recession feature GDP well below potential.’
The chart below is figure 2 referred to above. It shows a sizable output gap existing right now. I’m not sure how you get an inflationary breakout under these conditions.
Source: Congressional Budget Office
Still, that doesn’t mean inflation expectations won’t increase. That is clearly what is happening now. The market is discounting the expectation of future inflation, meaning overpriced tech stocks are de-rating, bond prices are falling, and gold is also under pressure.
On a positive note for gold, it is still hanging in there. Even after the overnight sell-off, it’s trading just above important support. Whether it can hang in there in the face of rising bond yields is another question.
You might be wondering why gold is falling in an environment of rising inflation expectations. Are we told that gold should do well in such a situation?
Well, it doesn’t really work like that. Gold responds to REAL interest rates not nominal rates.
According to Treasury data, the real US 10-year bond yield was minus 1.08% at the start of the year. As at 25 February, it was minus 0.6%. Still in negative territory, mind you. But less so than before.
But in the same way that gold doesn’t like positive real rates, either does a global economy awash in debt.
It’s just a question of how long it takes for rising real rates to have a detrimental impact on economic growth. And when that happens, you’ll get a Fed and government there to ‘help’.
That moment could still be six months away, or it could happen sooner.
The point is, I don’t think you should get too carried away with the inflation narrative. It will come eventually, but not yet.
And because of this, I believe the stock market is still the best place for your money. Yes, there are some crazy parts of the market right now. But there are also a lot of good value opportunities out there that should do well in the years to come.
As this correction kicks in, don’t succumb to the fear. We haven’t had one in a while and corrections are just a part of the investing game.
On this front, you’ll see an invite from me to a special upcoming event over the next few days. It’s got to do with how I see the market unfolding over the next few years, and the best way to play it.
I hope you’ll join me!
Catch you next time,
Editor, The Rum Rebellion
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