We’re going to mix things up this week and begin our discussion with gold, which has finally broken out to the upside from a multi-year consolidation pattern. As you can see in the weekly chart below, gold has climbed above long-term resistance near 1375, and completed a bullish breakout of its ascending triangle pattern.
Does this mean gold is off to the races?
There are no certainties, but gold does have a few tailwinds that could propel it higher. These include a resurgence of negative yielding debt, a dovish tilt by the Federal Reserve, and a resumption of exotic central bank monetary policy.
Last week, the universe of negative-yielding bonds grew by about $1.2 trillion on the back of dovish central bank messaging. The amount of worldwide debt with negative yields surpassed $13 trillion for the first time ever.
In the chart below (courtesy of Zerohedge), the total amount of negative yielding debt is shown in red, superimposed against the price of gold in, well … gold. As you can see, there appears to be a reasonably strong correlation between the two, with both items simultaneously reaching short-term highs in early 2016, lows in 2018, and then new highs just recently.
This relationship makes perfect sense when one considers that interest on alternative safe investments represents an opportunity cost to owning gold. When the interest on these alternative assets falls, it makes gold more appealing, and when that interest rate goes negative, it means there is an implied benefit to owning gold.
If you were one of the many institutional investors who believed negative-yielding sovereign debt was the best place to park your money, gold can actually provide some relief. Not only will you not have to pay anyone to borrow your money, you naturally have a hedge against geopolitical events and monetary debasement as well.
In addition, with global central banks expected to ease in the near future and dip their toes back into the exotic monetary policy bucket, that tailwind is likely to become stronger. There is no guarantee this move will be sustained, but it’s one of the most positive developments we’ve seen in the gold universe in quite some time.
To grasp the magnitude of the recent drop in yields, take a look at the chart below (data from Refinitiv), which shows yields across a wide swath of global sovereign debt. The red bars indicate negative yields, while the gray bars indicate positive yields.
Is it any wonder that capital continues to flow into our stock and bond markets, pushing stocks higher and yields lower?
In fact, demand for Treasuries has been so strong that it’s pushed the yield on our bellwether 10-year T-note down below 2% for the first time since 2016.
And yet, our 10-year still yields significantly more than many other developed countries, all of which are moving lower in tandem.
This dynamic leads to two important questions: How much lower will yields go? And what effect will all this have on stock prices? These questions are incredibly difficult to answer, but also incredibly rewarding if we can get them right.
As far as bond yields are concerned, one of the key things to remember is that longer-term yields track the outlook for inflation. If we can predict how inflation is likely to behave, we can get a good idea of how the long end of the yield curve will move.
But it’s not actual inflation that matters, it’s expected inflation. And right now, inflation expectations, as measured by the 5-year forward inflation rate, remain relatively resilient at 1.8%.
In addition, as we saw last week, the Trimmed Mean PCE inflation rate is holding steady and correctly identified the last two downturns in core inflation as transitory. Could it be right again?
A third and final piece of evidence that suggests inflation may not fall dramatically is producer prices. As you can see below, growth in the Producer Price Index has been rolling over, but producer prices are still rising by 1.9% (headline) and 2.3% (core) on an annual basis. Higher producer prices do not always translate to higher consumer prices, but it’s an indication that some pricing pressure does remain.
To me, this suggests that longer-term yields may not head much lower in the near term. If you’ve enjoyed this wave of higher bond prices, it may be a good idea to lock in some of those gains and wait for prices to correct.
Moving on, let’s talk about equities. Perhaps the biggest question facing investors is: Does the drop in yields that we’re seeing indicate a recession is imminent?
The reason this question is so important is because if the answer is no, then the drop in yields should lead to higher stock prices. All else being equal, it makes every company’s future earnings stream more valuable in today’s dollars, and it pushes us back toward a TINA (There is No Alternative) environment.
We can understand this more clearly by comparing bond yields against the earnings yield, which is the inverse of the P/E ratio.
Currently, Treasuries yield about 2%, while the market’s forward multiple is 16.8 (Factset). This latter figure translates to an earnings yield of nearly 6%. In other words, right now every dollar invested in stocks should generate about 6 cents in earnings, representing a 6% annual increase in value (again, all else being equal).
The question, of course, is whether that increase in value can actually be extracted from stocks down the road (via dividends or share price increases), or if market conditions will deteriorate to the point where that value disappears.
The additional risk of realizing the value increase from an investment in stocks is the main reason why earnings yields typically hover a few percentage points above bond yields. But when that spread expands far enough, it attracts money from bonds back into stocks. I think this dynamic may act to buoy the stock market in the near term.
But then again, if a recession is imminent, then all of this logic becomes useless. In that case, we’re likely to see bond yields fall significantly further, as investors look to park as much cash as possible in government bonds. A drop in yields for that reason would obviously be bad for stocks prices, as the bullish nature of lower yields would be more than offset by a deterioration in expected earnings.
Right now, the main recession warning indicator that is flashing red is the yield curve. But again, an inverted yield curve still leaves us with a relatively large window (6 – 24 months) during which the anticipated recession could occur. A lot can happen during that time.
Aside from the yield curve, one of the other important indicators to watch is The Conference Board’s Leading Economic Index (picture below). While it’s upward trajectory has slowed, it has not yet rolled over as it typically does in advance of an approaching recession.
When you also take into account that credit spreads have not risen dramatically, and most PMIs have not fallen into contraction territory, I think it’s fair to say that a recession is likely approaching, but is not imminent.
As a result, what I would suggest is this: Maintain your core position in equities, but perhaps consider shifting that allocation toward more defensive sectors, which would include Real Estate, Health Care, Utilities and Consumer Staples. If the market does begin to roll over, those sectors should hold up the best, as well as provide the longest window for paring back exposure.
In terms of trading around that core position, I’d remain relatively neutral, perhaps erroring on the side of being a seller. We missed our opportunity to buy on weakness at the beginning of June (due to the snap-back rally following Chairman Powell’s comments), and there is no compelling reason to chase the market here.
Let’s end with a quote from James Mackintosh at the Wall Street Journal. Speaking with regard to the current environment, he said:
But look deeper, and there is something else afoot: A rising sense not of imminent trouble but of a realization that central banks might not be able to spark growth and inflation, and that a stubborn shift lower is the new way of the world.
We’ve discussed this, most recently in a January article titled Setting Longer-Term Expectations, which might warrant another read. The big picture idea to keep in mind is that economic growth is a function of labor force growth and productivity growth, and central banks have little influence over either.
In addition, the trend toward lower labor force growth and productivity growth is a global one, not just something we’re experiencing here in the states. We must always keep this idea firmly planted in the back of our minds, as it will guide our long-term investing and allow us to remain sober in the face of politicians, central bankers and market pundits who consistently make unrealistic claims.