Either stocks are wrong in predicting a better world or bonds are incorrect in forecasting a continued soggy global economy. So which is it? With Treasury yields flirting at 1.7%, German Bund yields falling to 1.2% and Japanese government bonds yielding only 0.5%, the G7 bond market is saying that global growth will be problematic and inflation, absent. However, there is no inconsistency in the marketplace. Many U.S. and international stock indices have rallied on a sharp reduction in perceived financial risk, not necessarily on a quick turnaround in global growth. With European Central Bank (ECB) President Mario Draghi having made an explicit commitment to monetize troubled debt and protect the euro’s integrity, the ECB has effectively removed the risk of catastrophic European banking system failure and restored the path towards financial stability.
Nonetheless, we should remember that underlying growth for the global economy has not changed much despite higher stock prices. A savings glut remains in place. The euro zone is still in recession. Japan’s nominal stagnation has not ended. The U.S. economy could turn out to be stronger than expected, but fiscal restraint will undercut growth this year. Meanwhile, China’s reflation campaign has been hijacked by a sharp spike in property prices. In addition, many investors wonder what will happen to stocks once long term interest rates rise. But realistically, yields could stay low and potentially even dip lower before heading up sustainably. By the same token, one could argue that equity multiples should steadily expand if bond yields head higher. Higher yields would indicate better growth, higher expected returns, and a shrinking savings glut: all positive for equities. Hence, the key threat to stocks may not be rising bond yields, at least at the early stage.
The defining feature of the post-2008 world has been chronic excess savings, private sector savings in excess of private sector investment. Since the 2008 global crisis, private sector savings as a share of U.S. GDP has soared by 6%. For Europe, the jump has been even sharper. In the meantime, private investment has collapsed, opening up a huge savings gap in the developed world of probably $3.4 trillion. In a world of savings glut and zero interest-rates, foreign exchange rates are the only economic tool left that can alter the monetary conditions of an economy and change its relative competitiveness. Since the 1990s, when oversupply emerged as a dominant global force, there have been a series of currency devaluations as nations tried to fend off deflationary pressures and stimulate growth. Thus, competitive currency devaluation will continue to help dictate global financial markets.
All of this suggests that despite rising stock prices, growth remains in shortage, savings remain excessive, and fiscal restraint is hurting rather than helping the world economy. Global GDP growth this year is likely to be a tad stronger than in 2012, but not by much. So what is the bottom line? Stocks are rising on risk reduction. Bond yields are falling on the savings glut and fiscal austerity. Of course, no one should trivialize Fed policy. The Fed’s reiteration of continuing bond purchases has also taken out any concern about the central bank selling Treasury bonds, providing a continued boost to bond prices. And now, the Bank of Japan (with approximately $55 billion of purchases per month and a 2% inflation target) will be even more aggressive than the Fed. As a result, a price overshoot for risk assets could be a key phenomenon that dominates global capital markets for the remainder of the year.
Meanwhile, commodity bubbles are slowly being deflated by a sharp increase in supply and a gradually strengthening U.S. dollar. Lower commodity prices will negatively impact the equity market performance of many commodity producers. For the euro zone market, it is obvious that the distressed equity markets have been bombed out, which usually sets the stage for a sharp rebound. However, Italian politics, migrating crisis points in Cyprus and Slovenia, weak confidence, and an expensive euro could continue to delay recovery.
In April, expect North Korean threats, Venezuelan elections, U.S. gun control and sliding gold prices to capture headlines. Over the next few months, anticipate some budget compromise in Washington D.C. and projections of a declining Federal deficit. In addition, a stronger U.S. dollar may help make small cap companies more attractive relative to large cap companies that earn a larger percentage of their income overseas.
Michael Ashley Schulman, CFA