Is the Bond market crashing the equity party?
If you want to know where the stock market might be headed, you have to look at the economic gravity being exerted by the bond market. Right now, U.S. stocks and bonds appear to be on a dangerous collision course.
Think of it in terms of a feedback loop: soaring stock prices have made U.S. households feel incredibly wealthy – with equity holdings sitting at a record 250 per cent of disposable income – which keeps consumer spending hot and inflation sticky. At the same time, tech giants are pouring billions into data centres, further heating up the economy.
As the new U.S. Federal Reserve Bank Chair, Kevin Warsh, just hinted, inflation won’t come down. So bond yields won’t drop until the stock market takes a meaningful breather to cool things off.
It’s left the Federal Reserve (the Fed) completely boxed in. The U.S. two-year Treasury yield has crossed above the Fed funds rate – a technical signal that has successfully predicted a Fed rate hike every single time over the last 30 years. With core wholesale inflation (Producer Price Index (PPI)) surging at an annualised rate of 6.6 per cent, the Fed is cornered. Whether they raise rates or stay on the sidelines, the market will struggle with a hawkish central bank. If the Fed hesitates, the bond market will sell off even further because investors will realise policymakers are falling dangerously behind the inflation curve.
Market breadth?
Investors should always look under the hood to see what’s actually driving a market rally. And right now, the engine looks a little fragile. While the NASDAQ and S&P 500 are hitting record highs, it’s being driven by a handful of megacaps. It’s not news that the rally has been almost entirely driven by speculative mania surrounding artificial intelligence (AI) and semiconductor stocks. If you strip away the Technology, Media, and Telecom (TMT) sectors, the broader stock market is actually sitting well below its February highs.
Indeed, just 55 per cent of stocks in the S&P 500 are trading above their 200-day moving average, and the market’s overall advance-decline line has rolled over. Even more telling, the correlation between individual stocks has hit a record low, meaning a tiny handful of overbought tech names are dragging the entire index upward. When market participation is this narrow, it means the foundation is weak.
History tells us that this extreme decoupling always ends the same way: the broader market experiences a sharp downward ‘shift’.
Credit cracks and global contagion
The final piece of the puzzle is that the cracks aren’t confined to equities. According to macroeconomics researchers, BCA, yields on high-yield U.S. corporate bonds are rising, and their credit spreads are widening. When the extra premium required to hold risky corporate debt starts going up, it is an early-warning signal that credit investors see trouble ahead for corporate cash flows.
The fragility seen in the U.S. is also observable internationally. Indeed, the emerging market equity rally is even narrower than the U.S., with most international stocks languishing unless they happen to manufacture microchips in Asia.
Mainstream emerging market currencies are flatlining against a strong U.S. dollar because they are bearing the brunt of rising global food and energy costs. And, again, according to BCA, outside of the AI hardware bubble, global corporate profit outlooks are under severe pressure as higher interest rates and commodity inflation choke off real consumer demand.
It looks like the risk-reward ratio for equities right now is incredibly poor, and a notable shakeout could be brewing.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
