One Economy, Two Views for Stocks, Bonds
Despite meager gains last week, stocks are up sharply this year as investors bet on an economic recovery in the second half of the year and an end to the 3-year-old bear market.
At the same time, Treasury bond yields have plunged, falling to their lowest levels in more than 40 years, as fixed-income investors anticipate economic weakness.
So who is right?
“There’s a fight going on between the equity and bond markets,” said Andrew Clark, senior research analyst at Lipper Inc.
“The stock market is confident that the economy is going to turn around. The bond market is shaking its head and saying, ‘You guys are up on vapors.’ ”
Vapors or not, stocks and bonds are both on a tear.
The blue-chip Standard & Poor’s 500 index has risen 12.4% year-to-date; by historical standards, that would be a nice return even for 12 months.
The rise has come despite a string of ambivalent economic reports. Recent data showed the U.S. jobless rate rising to 6.1% in May, for example; and on Friday, the market slid as reports showed consumer confidence worsening in June and wholesale prices dropping for the fourth straight month.
Banking on better corporate profits in the second half, investors have shown a big appetite for risk, bidding up the technology sector. The tech-heavy Nasdaq composite index is up 21.8% in 2003.
By their historical standards, government bonds are performing even more impressively than stocks. The average U.S. Treasury mutual fund gained an “extraordinary” 1.4% in the five days ended Thursday, according to Lipper Inc., and is up 6.6% year-to-date.
The gains have been fueled by collapsing yields -- falling interest rates boost the value of existing bonds. The yield on the benchmark 10-year Treasury note fell almost a full percentage point between March 31 and Friday, when it closed at 3.11%.
“Without question this is one of the most impressive Treasury rallies we’ve seen,” said Eric Jacobson, senior analyst at fund tracker Morningstar Inc. in Chicago. “Fund managers are being confounded.”
Bond yields have been falling in part because fixed-income investors are focusing on the weak economic data that stock market bulls appear to be ignoring. As the Federal Reserve’s June 24 and 25 meeting nears, the debate is not whether the central bank will trim interest rates, but by how much -- a quarter-point or half a point.
The half-a-point camp has been growing with the release of every lackluster economic report, but many analysts believe that the Fed will save one more bullet for later this summer if the data stay weak, especially with money market mutual funds yielding a paltry 0.68% on average. Those record lows are taking a toll on savers and on the $2.2-trillion money fund industry as assets shrink, and a further rate cut would push those returns lower.
The Fed has signaled that it will chop rates once again to stave off the danger of deflation, and that, with no inflation on the horizon, it doesn’t expect to hike them any time soon.
Strategists trying to guess the size of the next cut will be watching this week’s economic calendar closely, including Tuesday’s release of the consumer price index as well as industrial production data for May and Thursday’s weekly update of new jobless claims, which have been running above 430,000 in recent weeks.
Though there is not yet any proof that the Fed’s series of rate cuts is sparking the economy, analysts say the central bankers are succeeding in pushing down mortgage rates, thereby boosting the housing market.
“We’re seeing exactly what the Fed wants to see,” said Bob Gahagan, director of taxable bond investments at American Century Investments in Mountain View, Calif. Falling interest rates are keeping the mortgage refinance market booming, and that’s providing a key source of cash for consumers.
The risk faced by holders of longer bonds is that rates will turn around, depressing the value of those securities. Still, despite warnings of such a whipsaw effect for more than a year, the risk may not be imminent.
“We could go through a long period of low rates,” said Mario DeRose, fixed income analyst at brokerage Edward Jones in St. Louis. He noted that for most of the span from the 1920s through the mid-1960s, key interest rates stayed under 4%.
Some strategists say it’s possible that both the stock and bond markets have it more or less right with their rallies.
“Taken together, what the markets are saying is that we’re going to see growth but not inflationary growth,” said Mark Kiesel, portfolio manager at Pacific Investment Management Co. in Newport Beach, which runs the Pimco bond funds. In that scenario, real gross domestic product growth might rise to about 3% in the second half, Kiesel said -- nominal GDP growth of 5% minus inflation of 2%.
Yet with both the stock and bond markets posting big returns so far this year, he cautioned that investors in both types of funds should not expect future gains to be so robust.
“A lot of your return has probably been made for 2003,” Kiesel said.
Both stock and bond funds pulled in large amounts of cash from investors in the first two weeks of June, said Bob Adler, whose AMG Data Services in Arcata, Calif., tracks fund industry trends.
The parallel trend is likely to change when clearer signs about the economy -- and the direction of the stock and bond markets -- emerge, Adler said.
“At some point there will be a divergence in performance,” he said. “We just don’t know when.”
