Attractive opportunities can still be found in dividend-paying equities and select fixed income sectors. However, the events overseas has mispriced many interest sensitive assets. The doom and gloom overseas has driven the 10-year Treasury bond this week to a record low of 1.35%. There has been a conundrum that has emerged between bond yields and equities. The bond markets are signaling a recession while the equity markets are pricing in future prosperity. So which will be right?
I believe that you need to toss out the old economic textbook. We find ourselves in a unique market environment. This time a flatter yield curve is not signaling a higher likelihood of a recession, but a slowdown in Europe. U.S equities rallied this week as the U.S economy created 287k jobs in June vs. a 175k expectation. More people are reentering the workforce, and employers are raising wages to attract skilled workers. The median price of an existing home continues to test record highs. This is a very bullish backdrop for U.S stocks. All major U.S asset classes have performed well this year, while countries around the world are still fighting deflation.
The search for yield in a low-yield world has pushed investors into dividend-paying equities. From a risk management perspective, this makes balancing risk much more difficult. Even DoubleLine Capital’s bond guru Jeffrey Gundlach said it was not prudent to buy 10-year Treasurys at these yields, calling them the “worst trade location” ever. The alternative to bonds is investing into a stock market near an all-time high. Can this trend continue and for how long?
I have communicated to my clients to brace for more upside and downside volatility. The low rate environment has made portfolio construction and risk management much more important. Going forward, I believe that the biggest market risk is if interest rates continue to move lower. Earlier this year, when oil prices were at their lowest point, I wrote that the biggest risk to the economy was if oil prices kept falling. Markets did recover as oil prices rallied. If interest rates do continue this downside trend, it could be a signal that a major financial institution in Europe is in distress. The U.S economy needs to avoid falling into the same deflationary spiral that is plaguing Europe. Interest rates will need to stabilize soon in order to prevent mispriced securities forming into a new threatening asset bubble.
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