Column: Stocks’ glass half full, bonds’ is half empty

Rude corporate health once again allows record-high Wall Street stocks to put a rosy tint on the U.S. economy – even as their more sober bond market cousins raise a red flag on the same outlook.

Maybe the truth is somewhere in between, and in some ways it was always thus – bullish equity and bond managers are paid to be simultaneously optimistic and gloomy about the same economy churning outside their windows.

But this week more than most prods investors to pick a lane.

The long end of the U.S. Treasury yield curve inverted – putting 30-year yields below the 10-year for the first time since 2019, and below the 20-year for the first time since that bond debuted last year – as data showed U.S. economic output slowed sharply in the last quarter.

And yet the S&P 500 zoomed towards yet another all-time high.

Equity strategists are looking through growth wobbles, inflation, imminent Fed taper, and likely liftoff on interest rates next year. The S&P 500’s recent 6% slip looks increasingly like a blip.

Corporate cash flows are strong. Some 82% of the S&P 500 companies that have reported Q3 results so far have beaten earnings expectations, and revenue growth is offsetting higher costs, with 77% of firms beating revenue forecasts.

Profits for S&P 500 companies are expected to grow 37.6% year-on-year in the third quarter, according to Refinitiv data. That’s sharply down from the second quarter, but Q2 growth was inflated to historic highs above 60% by a pandemic-skewed April-June trough last year.

Earnings growth is strong even without the favorable base effects, and the outlook remains positive. This is helping to lower lofty price/earnings ratios, making stocks less expensive even though the index is near record highs.

After cutting dividends, slashing investment, raising cash from asset sales, and cutting share buybacks at the height of the pandemic, firms are putting that huge pile of accumulated cash to work as the recovery continues.

Morgan Stanley economists reckon the U.S. economy is enjoying its strongest capex cycle since the 1940s, led by business investment in equipment and intellectual property.

Capital investment could reach its pre-COVID trend perhaps by the end of this year, and real investment growth in the first half of this year was running at an annualized 11.1%, their research shows.

By many measures, stocks still offer a better return than bonds. There is something of a virtuous circle at play here too: a gloomy bond market depresses long-term yields and makes equities more attractive, especially big tech, which accounts for more than a fifth of the S&P 500’s market cap.

Stocks can sometimes benefit when growth and bond yields are rising, and when both are falling.

“It all comes back to TINA – there is no alternative,” says Jon MacKay, senior strategist at Schroders.

YIELD CURVE INVERSION

But the bond market’s warnings of a wobbly economy, implicit in the inversion of the yield curve, are getting louder.

Figures on Thursday showed that the U.S. economy grew at an annualized 2.0% rate in the July-September period. That was down from 6.7% the previous quarter, the slowest in a year, and less than the 2.7% forecast.

In fact, if the 2.1% rise in inventories is stripped out, the economy actually contracted 0.1%, pretty much as the Atlanta Fed’s real time GDPNow forecast had predicted.

The yield curve flattening which has been underway for weeks, particularly at the long end, accelerated on the news.

That inversion comes at one of the most illiquid parts of the curve. But inversion is still inversion, and flattening pressures are spreading back towards the short end of the curve.

The gap between 10- and 30-year Treasury yields is now 39 basis points, the smallest in two-and-a-half years; the 5s/30s curve is the flattest since March last year; and the closely watched 2s/10s curve has flattened 30 basis points in a week.

For the economy – and Wall Street – a lot now depends on the strength of the U.S. consumer. There is growing concern that inflation may squeeze consumer spending, darkening the outlook for corporate revenues and economic growth alike.

Economics professor and former Bank of England policymaker David Blanchflower, and fellow professor Alex Bryson, argued strongly in a working paper this month that “clear downward movements in consumer expectations” since May point to a looming recession, even though employment and wage growth data suggest otherwise.

“It seems to us that there is every likelihood that the U.S. is entering recession at the end of 2021,” they conclude.

They acknowledge it is a bold call. But if the economic temperature continues to drop into the winter, it is only a matter of time before Wall Street feels the chill.