The Treasury-bond market is looking erratic again.
Amid a global economic slowdown and uncertainty about Greece and Ukraine, yields plunged in January and then surged in February. Money fled to bonds' safety when investors were fearful, and moved elsewhere when the fears abated.
The sharp swings are unsettling for bond investors, but they are probably fine for stockholders because, for all their jumpiness, yields remain remarkably low. Low yields are great for the economy and the stock market.
Stock performance reflects that. Despite the bond instability, the S&P 500 returned to record territory Friday and the Dow Jones Industrial Average came within a whisker.
Bond yields have been exceptionally low since the financial crisis, amid sluggish global growth and central-bank efforts to stimulate economies by keeping yields down. Low yields hold down lending rates, which keeps a lid on borrowing costs and stimulates corporate profits and consumer spending.
A growing economy with low interest rates and low inflation is a great mix for stock investors.
"It is good, absolutely. I expect a decent market this year," said David Joy, chief market strategist at Ameriprise Financial Inc., which oversees $810 billion in investments. He thinks the S&P 500 can rise 10% including dividends if inflation and yields don't rise much and the economy keeps growing.
That raises two questions. If low bond yields are so desirable, why are yields so erratic? And if yields aren't a problem for stocks, what could be?
Yields have confounded bond experts lately. When the Federal Reserve started talking in spring 2013 about eventually raising interest rates, the yield of the 10-year Treasury note was as low as 1.63%. It jumped to 3% at year-end. Then, with the Fed's plans unchanged and experts predicting higher yields, it slowly fell to 1.67% by Feb. 2 of this year.
Longer-term yields turned out to be less affected by the Fed than by the economic slowdown that hit Europe, China, Japan and the developing world. In Japan and Germany, yields fell even lower than in the U.S.
The global slowdown helped stifle U.S. inflation. The Fed's favorite inflation gauge, based on consumer spending and called the core PCE index, fell to 1.3% a year in December, far below the Fed's 2% target.
Meanwhile, because the safest foreign bonds yield so little and because fears about Ukraine and Greece made some investors seek safety, foreign demand for U.S. bonds soared. That demand pushed up bond prices, and rising prices push yields lower. So low inflation and high demand kept U.S. bond yields low. Renewed hopes regarding Ukraine and Greece reduced the fear factor, pushing the U.S. 10-year yield up to 2.02% on Friday, although Monday's snag in the Greece negotiations could affect markets Tuesday.
Throughout, the bond market's message has been consistent: Yields and interest rates are low. Upward pressure is modest.
"As long as you don't believe the downward tug on yields is driven by a meaningful deflation risk, low rates are excellent for the economy and the stock market," said David Donabedian, chief investment officer at Atlantic Trust, which oversees $26 billion.
The risk to this picture would be a jump in inflation. And right now, the main pressure is the other way: For global weakness to keep U.S. inflation well below the Fed's 2% target, said Michael Gapen, chief U.S. economist at Barclays PLC.
Because core inflation is below 1% in Japan, China and the eurozone, and because commodity prices are low and U.S. wage gains modest, there is little pushing U.S. inflation up.
"It is not a big material issue for stocks" as long as the economy avoids outright deflation, which it seems to be doing, Mr. Gapen said.
What are the big material issues for stocks?
At the top of Mr. Gapen's list is earnings. Weak global growth is great for interest rates, but not for multinational companies' sales. Weak global economies have helped drive crude-oil futures down 51% since June 20. That has damaged earnings for oil companies and for those that do business with them. A strong U.S. dollar has made things worse, reducing the value of money earned abroad.
Analysts' forecasts for S&P 500 companies' 2015 profit gains sagged to 2.4% on Friday, from 12.5% in mid-September, according to Thomson Reuters I/B/E/S. If the world economy keeps weakening and oil falls again, the profit outlook will get worse.
Fortunately, there is good news on both fronts. Growth for countries that use the euro improved slightly in the fourth quarter, the European Union's statistics agency said Friday. And crude-oil futures have rebounded 18.7% in New York since Jan. 28.
Analysts also expect U.S. companies outside the energy sector to hold up well this year, with 9.2% earnings gains, Thomson said.
A second worry is global instability. A breakdown in talks in Greece, or worsening tensions with Russia in Ukraine, could hurt stocks.
Stocks are sensitive to these issues because of a third problem: high stock prices. On Friday, companies in the S&P 500 traded at 20.4 times net profits for the past 12 months, far above the historical average of 15.5, according to Birinyi Associates.
The economic backdrop is favorable enough that U.S. stocks can keep rising despite those lofty prices, but only if earnings don't collapse more and Greece and Ukraine avoid disaster, money managers said.
"The conditions for a bear market don't really fit" with the current economy, said Mr. Donabedian of Atlantic Trust. A bear market is commonly defined as a stock-index drop of 20% or more.
"The U.S. economy is performing reasonably well, interest rates are low and should stay low for some time and earnings are reasonably positive," he said. He says stock gains may be limited to 6% or 7% this year, but he is forecasting gains.
(END) Dow Jones Newswires
February 16, 2015 17:16 ET (22:16 GMT)
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