Competing Narratives

In an abrupt turnaround from last week’s sell-off, the S&P 500 rallied 3.3% to close just below an all-time high. Equity markets charged headlong through a very eventful week. The Iowa Caucuses were wrought with controversy, the President of the United States was acquitted on two articles of impeachment, China reduced tariffs on $75 Billion of U.S. goods, payroll numbers blew estimates out of the water, and all throughout earnings reports rolled in and Coronavirus spread. As markets digest these events, two different narratives are forming in opposite corners. The narrative in the equity market is built around the idea that the global economy is improving, and President Trump will consequently be re-elected. The bond market, however, looks much more concerned about economic growth. The various yield curves are once again very flat, and their tone is increasingly diverging from the equity market and Fed intentions. 

There is merit to the idea that the global economy should pick up this year. U.S. and global PMIs have begun to hook higher just a month after the signing of the “phase one” trade deal. Earnings reports have also generally been stronger than estimated and are perhaps a sign of good things to come in 2020. Coronavirus remains a risk, but it is possible we’ve seen the peak speed of its spread. There will undoubtedly be some weakness in Q1 growth as a result, but it will be more important if business confidence can get back on track quickly. In addition, there is no reason to doubt the strength of the U.S. consumer with jobs gains coming at 225K vs. estimates for 158K and wages growing at 3.1%. A strong economy is good news for President Trump and is being reflected in term-high approval ratings. His re-election odds are surging this week based on a combination of the approval ratings, a messy democratic primary shifting to the left, and beating impeachment charges. The equity market looks to have bought into this idea for the moment. 

On the other hand, the bond market is acting very differently. Despite reasonably good economic developments, treasury yields have failed to gain much traction higher after being in free fall for the last month. As noted, the curves are flattening again and seem to suggest that the Fed still might be too tight. Fed Fund futures imply that the Fed will cut 2 more times this year, yet the Fed itself continues its move towards the sideline. The idea here must be that the soft patch we are anticipating in Q1 could be greater than we are expecting. The disruption from Coronavirus, Boeing, and the lingering effects of a prolonged trade war will require further Fed action. A greater than expected slowdown in growth could have election implications that the equity market isn’t pricing in right now. If this is truly the case, the Fed is on the wrong foot and will have to adjust as they did last year. If not, we may expect yields to begin to trickle higher as they start respecting actual improvement in economic growth. 

A third story continues to play out in the background and ties the other two together. Structural forces continue to weigh on inflation across the globe regardless of any shorter-term improvement in economic growth. When coupled with a thirst for yield, it’s easy to see why rates remain as low as they do and why stocks look so attractive. In other words, it may be perfectly normal in today’s environment for stocks to be breaking to new highs as yields continue to fall. 

Preston May, CBE, Research Analyst