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Now would be a good time for investors to curb their enthusiasm a bit. This year started with the bulls mostly under control. U.S. stocks are already up about 4 percent, making this one of the strongest opening months of any year in the past decade.
The re-inauguration of Donald Trump as the President of the USA ushered in a new era “animal spirits” among business executives, as veteran investor Stan Druckenmiller said this week. CEOs are “somewhere between relieved and giddy” about the election results, he told CNBC. Meanwhile, American banks are in “go-mode“, JPMorgan’s senior executive told the crowd in Davos, while crypto is one step away from entering the “banana zone“, according to his boosters. (No, me neither. Obviously that’s a good thing, but it does indicate that prices are about to go up.)
HSBC stays with the good vibes. His multi-asset team this week described an “extremely positive” backdrop for risk assets in the first half of this year – a scenario he described as “Goldilocks on steroids”, quite a mental picture.
At the risk of spoiling all the fun, some market watchers – including some of the bullies – are getting a little nervous. The first big reason is the global government bond market, which had a shaky start to the year. That’s not entirely a bad thing—it reflects the continuation of America’s economic growth miracle. But it also reflects the expectation that inflation will continue to linger and that the Federal Reserve will therefore struggle to keep cutting interest rates — no matter how much Trump might want it. On the margins, it also suggests that asset managers require a slightly higher rate of return to fill government coffers.
Regardless of your preferred narrative here, the bottom line is that bond investors got it wrong (again) and the resulting drop in prices pushed up yields (again). The most important benchmark of them all – the US 10-year yield – is well above 4.5 percent. That marks a rebound in prices since mid-January, but is still high enough to undermine the case for increasing inventories.
Like my colleagues reported this weekUS stocks have now reached their most expensive point against bonds in a generation. It is increasingly difficult to justify further entry into stocks when their expected profits relative to earnings have fallen so far below the risk-free rate.
Peter Oppenheimer, chief global equity strategist at Goldman Sachs, noted at an event at the bank’s posh London office this week that stocks have so far largely avoided this bond competition – in large part because optimism around growth is so strong. But that leaves the stock now “vulnerable to further increases in yields.”
It’s a little silly, but still true, that a lot here depends on round numbers, which act as useful psychological guides for investors. The big test would be if US yields hit 5 percent. At that point, one of two things would happen: the bond haters would capitulate and make some bargains to drive yields down again, or selling would intensify and every asset class would feel the pain. My strong hunch is the former.
We’re not at that point yet, but as Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said this week, “we’re still at a critical level.”
“We’re getting really close to a zip code where slightly slower growth and slightly higher rates become a lethal combination for the markets,” she said. As a result, she is skeptical that stocks in general, and the highly concentrated, highly technology-dependent U.S. stock market in particular, can continue the spectacular run of the past two years. Shalett predicts US stocks will gain between 5 and 10 percent this year. That’s not bad, by any means, but it wouldn’t be a repeat of the 20 percent performance in each of the past two years.
Another alarming factor is the sheer level of optimism, especially among retail investors. The American Association of Individual Investors reported that sentiment “jumped into the sky” in its latest monthly survey. Expectations that stock prices will rise in the next six months jumped some 18 percentage points through January, the AAII said.
Even the optimistic wealth managers who advise many of these investors are having a hard time keeping them. Ross Mayfield, investment strategist for Baird Private Wealth Management, told me this week that he believes in a bull market, albeit with half an eye on bond yields, which have moved “up and to the right for no apparent reason.” But he sees anecdotal signs that the theme of American exceptionalism is becoming too entrenched among his clients. “I’m starting to get questions about whether to diversify at all,” he said.
None of this is a reason to run for the hills and take refuge in the safest means you can find. But the air gets a little thin at these heights and the potential for missteps by the new US presidential administration is strong. Glassy-eyed optimism rarely ends well, no matter how muscular Goldilocks is.
katie.martin@ft.com
