Bonds vs. Stocks – The Next Round
Posted on August 11, 2017
By Timothy P. Vick, Director of Research
Market strategists seem eminently conflicted at the moment. At a time when macroeconomic conditions are relatively benign, even upward sloping, the financial markets are throwing off mixed signals that have stock and bond investors wondering how to allocate portfolios. On the one hand, broad economic data from the U.S., Europe, and Asia continue to show that the nine-year expansion in production and lending that began in 2009 remains intact. This has pushed up equity prices to new highs. The data also show us that values of U.S. businesses continue to climb due to improved sales prospects, rising returns on capital, and effective use of cash flows.
Yet, bond markets seem to portend an imminent end to the expansion. Interest rates dropped in recent weeks, inflationary pressures that once seemed imminent have dissipated, and oil and commodity prices have retreated. Most importantly, the yield curve on government bonds has “flattened,” meaning that short-term and long-term bond yields have converged – historically that has signaled a softening economy.
These mixed signals, taken at face value, pose difficulty for managers who are trying to extend returns for clients and keep risk levels moderate. An economic slowdown would most certainly hold interest rates lower for longer, hurting both stock investors looking for growth and fixed-income investors needing higher yields. Better economic growth, however, would justify the stock market’s rally and give us continued opportunities to plant higher levels of income within portfolios.
Whether you’re desiring stocks or bonds, much hinges on economic growth and the movement of interest rates in 2017. The positive data – improved loan demand around the world, tighter job markets, strengthened bank balance sheets, and revived capital spending – all point to more-normal economic growth going forward and continued modest increases in interest rates. But we are watching closely sluggish U.S. productivity levels and retail consumption, both of which can naturally put a ceiling on GDP growth and keep it below policy makers’ 3% targets.
We’ll be guided by three trends as we navigate the tradeoffs between stocks and bonds:
A return to pre-Recession yields seems very unlikely to us. Prior to 2008, money-market funds yielded more than 5%, as did corporate bonds and municipal debt. We would “lock in” such yields for many clients today if they existed, but they cannot given the “New Normal” lower levels of money demand and economic activity.
Total returns on stocks and bonds are falling after multi-year rallies in both asset classes. Stocks, however, remain the preferred investment by a longshot. An investor who buys a 5% coupon-paying bond today faces the possibility of watching the bond drop 3% a year in price until maturity, for a total return of just 2%. Equity investors should benefit from near 10% earnings growth in 2017 and 2018, but with stocks trading at cyclically high premiums to earnings and cash flows, chances are good that investors ultimately obtain returns below companies’ earnings growth.
Our fixed-income strategy will have to stay nimble and evolve as we look for the best lower-risk income opportunities available at a given moment. Since 2008, we have ignored traditional government debt (where yields have nosedived well below 3%) and have alternately taken advantage of oversold corporate bonds, high-yield bonds, utilities, preferred stocks, REITs, oil and gas partnerships, and high-dividend paying blue-chip stocks. We will keep fishing these ponds until government debt offers adequate yields to compensate clients for the risks.
If you would like to discuss your own portfolio with one of The Trust Company’s investment analysts, we would be pleased to help you. Visit our Contact Us page for contact information across all of our markets or to request a meeting at an office in your area.
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