One of the interesting aspects of the market this year is that the sectors that are doing best are not the ones an investor would naturally expect. For instance, the sector which is blowing away the S&P 500 is utilities. The stocks have been doing so well, they are showing up in momentum oriented funds, which is a rarity. The sector is known for its solidity and stable returns, but right now utilities are hot. Over the last twelve months, utilities have returned 21.2% versus the S&P 500’s 7.3%.
FINSUM: You don’t usually think of utilities getting hot, but because rates are falling at the same time as real estate weakening, utilities are taking a lot of capital that is usually split with REITs.
In another sign of the deteriorating global economy, bond yields in Europe are once again moving negative. German Bund yields fell in trading recently and are now below zero. The move reflects the recently weak data coming out of Europe as fears grow about a recession there. Europe had seen negative bond yields for a long period until the brief bout of economic strength over the last couple of years.
FINSUM: Can the US be the odd man out in deflecting the global downturn? We have done it before, but this time feels different.
The bond market seems to have blind faith in the Fed right now. Longer-term bond yields have fallen dramatically, a sign that fixed income investors are sure the Fed is not planning any moves. Not only are bonds up considerably lately, but implied volatility is very low. That means investors are discounting both the chance for an inflation increase and an economic downturn. In other words, they think the economy and Fed is going to stay right where it is.
FINSUM: Can you blame them? The economy lingered in what we think of as an investor’s “goldilocks” phase for several years after the Crisis—inflation not too low, not too high, Fed on hold, asset prices rising. It does not seem unlikely we go back into that mode.
Bonds and stocks are sending different signals right now, and it is hard to tell which side is correct. Bonds are reflecting an increasingly bearish outlook on the economy, with yields falling. Stocks, on the other hand, have been jubilant so far this year. The reality is that both sides cannot be correct. Historically speaking, bonds have usually been more astute is measuring the direction of the economy and markets, and if that is the case, then we would be headed for a downturn.
FINSUM: The Fed really weighed in with its view yesterday and they are clearly worried about the direction of the economy. Are bond investors right again?
Right now might not seem like the most important time to buy rate-hedged or short duration funds. The Fed is supposed to be on “pause” after all. However, in our view, now might be a critical time to have some rate hedged assets in the portfolio. The reason why is that yields have pulled back strongly from just a couple of months ago, including yesterday, but given the fact that it is almost purely the Fed which has caused the sharp reversal, rates could swing just as wildly higher if their comments, or economic data, changes. In other words, the bond market looks overbought right now because of Fed comments, but it could easily snap back to where it was in December in violent fashion.
FINSUM: We think this is a time for caution on rates and yields given how strongly the market has reversed over the last couple of months.