February 4th, 2020

Chadd Mason, CEO The Cabana Group

The Emotional Stock Market vs. the Wise Old Bond Market

Last week, we discussed the coronavirus outbreak and implications it might have on markets going forward. I provided some statistics related to previous epidemics and the historical response to those by equity markets worldwide. That data is inconclusive at best. I ended the commentary by pointing out that this current medical crisis (like all worldwide events) does not matter to investors, until it matters. What I mean by that statement is that extraneous events don’t necessarily impact asset prices just because they happened, or just because they are scary. Events only matter if they affect the supply and demand of goods and services.

It is these fundamental underpinnings of the world economy that drive interest rates and the all-important perceived opportunity for yield, relative to a risk-free rate of return. If demand is strong, businesses will perceive an opportunity to profit by investment in their products (supply) to meet that demand and generate earnings above and beyond what could be achieved by investing the same capital in things like government bonds. When demand becomes weak, businesses may feel the possibility of generating earnings is insufficient for the risk involved in putting money toward growing their business.

It is this ongoing analysis that is played out every day and is reflected in the bond markets in general, and the yield curve in particular. It is the bond market and the yield curve that tells us what investors think about prospects for growth over the next 1 year, 3 years, 5 years, 10 years and more. Think of the stock market as a loud and sometimes argumentative teenager. It is emotional and bounces around a lot while trying to find its way. Think of the bond market as a wise old man. It doesn’t make as much noise or talk as much, but when it does speak it is worthy of attention.

Domestic and international stock markets (notably Chinese) have sold off precipitously during the past week as the coronavirus has continued to spread across the world, and global leaders have scrambled to quarantine large swaths of the Chinese and traveling population. It is now clear that the virus will infect significantly more people than the SARS virus did in 2003. Whether it is as deadly (on a relative basis) remains to be seen. Sectors with exposure to the Chinese economy, such as technology, have been hit especially hard. The energy sector, which is dependent upon Chinese demand has experienced the weakest start to a year in decades. The energy sector ETF (XLE) is down 16% in a month. Clearly, we are seeing at least the perception of demand being affected by this virus. But as stated above, stock markets bounce around a lot and perception can change overnight.

So, what says the wise, old bond market? Well, the bond market unfortunately looks like it agrees. The 10-Year Treasury Note has now dropped 40 basis points in just over two weeks. It is currently yielding 1.53%. That is a 20% move down and evidences real concern that global economic activity is going to be hurt going forward. In fact, we just saw the 90-Day and 10-Year Treasury Note invert. This means that an investor gets a better rate of return for loaning out his or her money for ninety days than for loaning it out for ten years. This is not normal and is not a good sign for economic growth going forward. This condition happened in 2018 and quickly resolved itself, which may happen again.

All things considered, I am not suggesting that we can’t or won’t find our way through this latest threat. Yesterday saw some buying in equity markets across the world and markets are up big today. Suffice to say, I am concerned that the bond market has rapidly forecast such weak demand in the face of good earnings here in the U.S. We are in the middle of earnings season and most companies are beating expectations. Bond markets often see things before everyone else does. That fact should give us pause going forward.

We remain moderately bullish for the time being at Cabana.


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