Everyone is trying to comprehend just how much the world has changed last week, including Wall Street traders.
In the days after Donald Trump was elected U.S. president, stock markets had their best week in two years and bonds suffered more than $1-trillion (U.S.) of losses. The main narrative behind the move was that Mr. Trump would spend more money to build roads and bridges, generally spurring growth and long-awaited inflation. That’s good for stocks and bad for government bonds.
Mr. Trump certainly changes the game in many ways. But he can’t change the fundamental backdrop of slowing global growth overnight, and basic investing principles still apply. While investors seem to have thrown caution to the wind as they plow into equities, at some point they’re going to turn around and like bonds again.
That point may come sooner than many think. Here’s why: In recent months, a main argument for buying stocks has been that equities provide regular dividend payments that are much higher than yields on benchmark government bonds. But that dynamic is shifting rapidly.
It makes sense to buy stocks that pay an earnings yield of 5.1 per cent rather than 10-year Treasuries that pay just 1.36 per cent. But what happens when those U.S. government bonds have a 2.2-per-cent yield and more safety than a basket of expensive stocks? Suddenly they become more attractive. Meanwhile, the S&P 500’s earnings yield is falling quickly as stock prices rise. Now, investors stand to earn the least amount of extra income from owning U.S. stocks relative to benchmark Treasuries in almost three years.
The question now is when will this stock-bond dynamic reach a tipping point, prompting a rush of money back into debt and out of equities. The calculation depends on many unknowns, such as the size of Mr. Trump’s stimulus plan and how he will pay for it. While almost everyone is predicting higher U.S. consumer prices, it’s unclear how quickly they’ll rise or whether paycheques will rise in tandem. Meanwhile, foreign investors seem to be among those temporarily boycotting U.S. debt, and it’s unclear how quickly they’ll come back.
But money is money. Investors will want safety. Eventually, bonds will look good again, especially compared with increasingly expensive equities.