Dueling Bull Markets And The ‘Jaws Of Doom’

This week saw the “dueling bull markets” theme perpetuated, as US equities raced to record highs, while 10-year yields dove below 2% for the first time since 2016.

Scattered throughout the financial press, analyst notes and various market-focused blogs are references to the so-called “jaws of doom” shown in the top pane below. The bottom pane is just a visualization of the simultaneous rally in equities and fixed income.

Obviously, equities are running on the assumption that Fed cuts (and the easing bias of the FOMC’s global counterparts) will help the economy avert a recession, while bonds are bid due to a trio of factors which I documented on Friday evening as follows:

Bonds are simultaneously reflecting i) central bank dovishness, ii) the growth jitters upon which that dovishness is predicated and, to the extent the path lower for yields is attributable to falling inflation expectations, iii) a lack of faith in policymakers’ ability to reflate the global economy. 

Do note that there are multiple layers of irony embedded in the interaction between those three factors.

So, is it true that the “jaws” have to close? Does someone (i.e., stocks or bonds) have to be definitively “right” in this scenario?

Not necessarily – or at least not in the near- to medium-term, according to Goldman.

“We would argue that there need not be a large convergence over the medium term of rates and equities; namely that rates need to steepen (or the back-end rise) to ‘catch up’ with equity prices or that equities need to sell-off to ‘catch down’ to the bearish implication of the yield curve”, the bank wrote Friday.

Needless to say, the body of literature on the relationship between equities and bonds is voluminous and not in any way, shape or form amenable to concise treatment (comprehensive and/or rigorous studies of this are the purview of academic studies), but Goldman notes that a relatively straightforward approach “suggests global equity multiples are in-line (or even slightly inexpensive) relative to the current mix of growth rates and yield levels.” Here’s a short excerpt and one visual from the note:

US equity valuations do not appear stretched based on a simple Fed Model approach (the current premium of EPS yield vs. Treasury yield is at the 5-year average). In Exhibit 2 below, we extend this analysis to global equities (MSCI ACWI). In addition to comparing equity valuations to 10-year yields, we incorporate 2-year rate levels and our global activity tracker (Global CAI, in level terms). We run the exercise since 2006 to capture the relationship in the recent regime of falling longer-term growth expectations and subdued earnings growth. A simple regression of these variables suggests that global equity multiples are in-line (or even slightly inexpensive) relative to the current mix of growth rates and yield levels.

The bank goes on to note that global equities are trading at about 15X, well off the highs seen during January 2018’s blow-off top (16.5X). Although current valuations for global stocks are, in fact, in the 78th percentile (versus their 15-year history), that’s not as ebullient as you might be inclined to believe if all you did was scan some headlines on market-focused web portals.

Of course, this doesn’t mean there’s not drawdown risk. The current geopolitical backdrop is hopelessly fraught and, as we saw in May, the market seems to have run out of patience with US-China escalations.

That said, the main risk to the equity rally is (somewhat ironically) the prospect of a hawkish disappointment from central banks.

“On a short-term basis, less accommodative central banks or a shift in perception that they will not deliver on cuts priced into the market pose headline risk to equities”, Goldman adds, before reiterating that, risks aside, the point is simply that “equities are anchored by growth (EPS more than GDP), and they should trade lower only if less supportive central banks deter growth from improving.”