9/18/2023

Current investor sentiment varies greatly between the stock and bond markets. You would think each market was looking at two completely different environments. 

Stocks appear to be ignoring the Fed’s highly restrictive monetary policy and responding positively to positive economic news. As measured by the S&P 500 Index, the market is up 17.2% YTD. Last fall, stock analysts lowered their forward quarterly earnings expectations, but since then, stock performance has been exceptional. For the balance of this year and into next year, stock analysts are projecting growing quarterly earnings. Stock investors seem to be little concerned by recession worries.  

A closer look at S&P sector performance provides some interesting perspectives.  During recessions, investors often seek refuge in defensive sectors such as healthcare, consumer staples, and utilities. These sectors are considered less sensitive to economic cycles and may provide more stable returns than those heavily impacted by economic downturns, such as consumer discretionary and industrials. So far this year, the healthcare, consumer staples, and utility sectors are down respectively -1.9%, -2.1%, and -6.4%, compared to the consumer discretionary and industrials, which are up 33.6% and 7.8%.  

In contrast, bond investors seem very worried about an economic slowdown. The yield curve, as measured by each of the 2 & 10-year treasury securities, has been negative and inverted for months. During recessions, the yield curve may flatten or even invert, meaning yields on longer-term bonds can be lower than those on shorter-term bonds. Historically, an inverted yield curve has often been a precursor for a recession 12-18 months forward. Perhaps bond investors have gotten a little ahead of their skis in forecasting a recession. I’ve always said that “recession hunting” is not always a fruitful endeavor.  

This week, the Federal Reserve Bank Board will meet and review its current monetary policy.  The consensus view is the Fed will leave interest rates unchanged at the current target of 5.25-5.50%. While recent declines in core inflation have been welcomed, the Fed still believes it has more work to do to rein inflation back to its 2% target. August core inflation data (excluding food and energy) has just come in at 4.35%, down from 4.7% in July. The next Fed meeting will be in November. Fed Funds futures are pricing a 40% probability of another 0.25% rate hike at that meeting. 

Perhaps the contrasting bond and stock market views will soon begin to converge.  Last Friday, 2 & 10-year treasury yields closed at 5.04% and 4.33%, just below their 16 and 17-year highs in 2007.  Just three years ago, these treasury rates were 0.10% and 0.51%.  Higher and more persistent long-term interest rates could be a crimp in the stock market, especially non-defensive growth stocks sectors. Meanwhile, deposits are still flooding out of the banking system because of the relatively attractive money market yields (currently near 5.4%) available elsewhere. All bets are off if we see 2-year treasury yields approach 5.25%. Stay tuned as this saga further plays out. 

Gary B. Martin