The stock market is a market for stocks. We have said this often enough. It means that stock prices (in the short term) are determined by the usual dynamics of market demand and supply, just as the price of any other market-driven assets, goods or services would be. For example, when there is a surge in demand (strong buying interest), the stock prices go up. Conversely, when the number of sellers overwhelms buyers, prices fall.
In other words, short-term market gyrations are a reflection of investor sentiment and emotions of the moment, whether it is panic, euphoria or ambivalence. You should, therefore, constantly remind yourself that the reasons analysts give for market gains and sell-offs are, very often, simply narratives tailored to fit the story, told in hindsight. The reality is that the stock market is not the economy, although it is generally efficient in reflecting future economic and corporate fundamentals.
The bond market is generally seen as a better gauge of longer-term economic growth and especially future inflation, which is captured in the prevailing yields. It is much larger than the stock market (in terms of value and volume traded) and is perceived to be more rational and less emotion-driven, being driven by very large institutional funds with some of the brightest minds.
If this is the case, then what is the deeply negative real yield (reflected in the prevailing yields of the Treasury Inflation-Protected Securities, or TIPS) in US Treasury bonds telling us? Do investors think economic growth in the US will slow sharply after the short-term recovery spike? At the very least, we think they are telling us that current inflationary pressures are non-threatening.
With US inflation jumping sharply higher — 5.4% in June, which is a 13-year high — on the back of a reopening surge in consumer demand amid prevalent supply bottleneck issues, narratives of 1970s-style stagflation are making something of a comeback among some market observers. Yet, yields on the benchmark 10-year Treasury bonds, currently hovering at around 1.3%, have fallen well off their recent peaks — at 1.74% in March.
Falling yields tell us that the bond market is unconvinced that the current spurt in inflationary pressures will persist and certainly not runaway inflation that will force interest rates sharply higher. In other words, the bond market rally — prices and yields are inversely correlated — is telling stock market investors that the threat of inflation is low. And that, in turn, is fuelling the stock rally. Remember, the value of a stock is equal to its discounted future cash flow. Mathematically, therefore, low interest rates translate into higher valuations.
On July 23, the Dow Jones Industrial Average extended its uptrend, recovering all lost ground from the sell-off on July 19 and more, closing above the 35,000-point milestone for the first time ever. The Standard & Poor’s 500 and Nasdaq Composite too are trading at all-time highs.
Apart from falling yields, the continued stream of upbeat earnings results is further bolstering investor confidence — and capping valuations despite rising prices. According to data provider FactSet, 24% of the S&P 500 companies had reported their results by the week ended July 23, 88% of which beat market expectations. Earnings growth for 2Q2021 was revised upwards to 74.2% year on year, from 63.2% as at endJune. Net margin for the quarter is now estimated at 12.4%, versus the five-year average of 10.6%.
Coming back to the bond market. Falling yields indicate that bond investors believe that prevailing higher-than-normal inflation rates are transitory. Still, who — apart from the central banks undertaking quantitative easing, which is price-insensitive — would buy bonds and earn negative real returns, and why would they?
Negative real yields for the benchmark 10-year Treasury bonds mean their holder’s purchasing power will be less at maturity. They will earn a paltry 1.3% interest annually over the next 10 years and their purchasing power will be eaten away by price increases, even if the inflation rate averages lower at 2% to 3%, unless inflation for the next decade falls below 1.3% on average. This either means very slow economic growth or very huge productivity gains are expected.
What other reasons could there be? Buying bonds with negative real returns may not make sense if that is all you are investing in. But it makes sense as part of a diversified portfolio strategy. Stocks offer higher returns while quality-rated bonds will lower your portfolio’s overall risks. Think of the negative real returns as the cost of insurance, in case the global economy falters even if it seems unlikely at the moment. Sovereign bonds such as those issued by the US, the UK, Japan and Germany are widely seen as “risk-free” and a safe haven in times of market distress.
Negative real returns on US Treasury bonds would also make sense to foreign investors whose domestic inflation is persistently low or even negative. For example, the inflation rate in Japan is barely above zero (see Chart 2). So, earning a nominal yield of 1.3% from US Treasury bonds will still give positive returns — as long as the exchange rate remains stable, and better if the US dollar appreciates.
Quite frankly, the problem is also too much liquidity. The world is suffering from excessive liquidity, and has been for more than a decade — the result of extreme monetary policies embraced by the major central banks, including the US Federal Reserve, European Central Bank, Bank of Japan and Bank of England.
With anaemic demand from investments (capex) — for example, Chart 3 shows US gross capital formation as a percentage of GDP since the 2008 global financial crisis has been well below historical averages — much of the massive liquidity has gone into financial assets, including stocks and bonds as well as real estate. Excessive liquidity is most likely responsible for the recent manias in cryptocurrencies, meme stocks and non-fungible tokens.
Big gains in asset prices are, in turn, widening the wealth inequality divide around the world. The rich own the bulk of assets and have a lower propensity to consume (saving more as a percentage of their income). Thus, the more asset price gains are accrued to the rich, the more there is leftover to be reinvested.
We foresee no major reversal in liquidity or big rise in interest rates for the near to medium term. All that money must find a home and the feedback loop just perpetuates the cycle of asset price gains. Interest rates in the US (and the world) will stay low for an extended period of time, though the Fed has indicated that it will be looking to gradually pull back on its US$120 billiona-month bond purchases. And this forms the basis of our global investment portfolio strategy.
Box Article: How countries performed in managing Covid-19
Covid-19 is a very emotional subject. Many have formed entrenched positions in their beliefs, so much so that, often, it is difficult to accept opinions outside of their own echo chambers. This is evident not just in Malaysia but also around the world. Over the past week alone, we saw thousands of protesters in multiple countries bringing their grievances — whether it is against mandatory vaccination, vaccine dividends or lockdown measures — to the streets. It is an understatement to say everyone is extremely frustrated and fatigued, whatever his or her beliefs may be, 17 months after the World Health Organization declared Covid-19 a pandemic.
There is no question that Malaysia could have handled the outbreak better — the country is currently in the midst of its worst wave yet. Obviously, the pandemic cycle is different in each country, in terms of timing for peaks and troughs. Some countries experience more intense waves earlier and others later.
For example, the worst of the pandemic in the US was in early 2021, just as the country started its vaccination rollout. As the percentage of population vaccinated rose, the death toll dropped precipitously. By comparison, the outbreak in Malaysia had been relatively well contained, until the current wave (see Chart 1).
Therefore, to get an accurate gauge of how effectively countries have handled the outbreak, relatively speaking, we must look at the death toll in totality, since the start of the pandemic. By this yardstick, Malaysia ranks 87 out of 183 countries in terms of death toll per million population (see Table 1) — but we could have, should have, done better.
Across the Western world, where individual freedom is often held above that of society’s good, it will inevitably mean more deaths as a trade-off. Conversely, measures often seen as “draconian” in these same Western countries — for instance, in more authoritarian regimes like China — have also meant a lower loss of lives and livelihoods.
Importantly, how each country has managed the pandemic is a reflection not only of its leadership but also its people, their attitudes, culture and choices. It is always easier to blame others than to accept the responsibility that, maybe, we all played a small part culminating in the situation that we are in today. A case in point: Despite the elevated outbreak right now, there are still hundreds of people fined for breaking standard operating procedures (SOPs) on a daily basis. This is probably very hard to hear. But we have always written our articles as honestly as we can, based on facts and by analysing available data — both quantitative and qualitative — that are viewed in totality. For instance, we have demonstrated how easily numbers can be manipulated to serve different agendas and how even seemingly immutable statistics are subject to biases, whether intentional or otherwise.
Most things in life require a trade-off — and, during the pandemic, that trade-off is between lives and livelihoods. How effectively each country has handled the crisis thus far — within the limits of its political structure and the people’s behaviour and cultural differences — is a reflection of this fact.
Chart 2 is a graphical representation of what everyone refers to as the “lives and livelihood trade-off”. We used the actual Covid-19 death toll as a measure for lives. While there is no precise parameter for livelihood, the closest approximation would be the country’s GDP — which measures the total income for the economy. In this instance, we used the forecast 2021 GDP compared with actual GDP in 2019 (pre-pandemic). We will elaborate further on the economic consequences of the pandemic and the reasons for the different impacts we see on GDP and the unemployment rate next week.
Clearly, there is only one sustainable solution out of this crisis — vaccination. Over the past weeks, we have published numerous charts proving how a rising percentage of population vaccinated in other countries has significantly lowered fatality rates. We are confident that, given our vaccination rate today, the number of deaths will start to drop soon. This is a fact, supported by hard data. Some may not believe this today — just as many did not believe Malaysia could ramp up the vaccination rate and “projected” as recently as a few months back that it would take us many, many months, if not years, to reach herd immunity. This is the fallacy of taking data at one point in time and using it to do a linear projection into the future (see Chart 3). It would be akin to multiplying the average daily diaper usage of a two-year-old healthy child today by 78 years to estimate how many diapers he would need by the time he is 80.
Make no mistake, the number of infections may well rise as vaccination gains steam. This is because the economy must reopen as soon as possible to prevent further damage to productive capacities and protect livelihoods. As the number of contacts between people rises, so too will infections — until we reach herd immunity — and the risks for the unvaccinated will be disproportionately high. We explained this is in detail last week (“Vaccination — the only way to save lives and livelihoods”, The Edge Singapore, Issue 994, July 26). And the statistics bear this out.
Table 3 is an analysis of recent Covid-19 cases in Singapore; and Table 3 is a press release from Malaysia’s Ministry of Health on July 26. The evidence is indisputable. And the message for all those yet to register for vaccination is very clear — get vaccinated!
It is also clear that “vaccine breakthrough” — where the vaccinated can still get infected — is a fact for the Covid-19 virus. The only option to us is to live with the virus, knowing that, once vaccinated, severe effects are unlikely even if you are to be infected by the virus. Some changes in social behaviour are undoubtedly going to stay with us — for example, constant handwashing, no handshakes and keeping some physical distancing.
At the risk of sounding like a broken record, each and every one of us has to do our part — get registered and get to your vaccine appointments — if we are to contain this outbreak as soon as possible, so that lives and livelihoods can return to the way they were, pre-pandemic. To hasten towards this goal, The Edge believes it is time to start the process of making vaccination mandatory.
- Box Article Ends -
The Global Portfolio was up 0.8% for the week ended July 28, led by gains from Singapore Airlines (+7.1%), Alphabet (+6.7%) and ServiceNow (+2.9%). Shares in Alibaba Group Holding fell sharply, down 9.8% last week as China’s toughened stance on regulatory environment for Big Tech spooked investors. Other big losers were General Motors (-2.7%) and Taiwan Semiconductor Manufacturing Co (-2.4%). The Global Portfolio returns now stand at 60% since inception. This portfolio is outperforming benchmark MSCI World Net Return Index, which is up 55.5% over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
Photo: Bloomberg
