The U.K. surprisingly votes to leave the Eurozone. There are multiple terrorist attacks in Europe and a failed coup in Turkey. Global economic growth remains lower than historical norms and the next U.S. president will have one of the highest unfavorable ratings since the term ‘unfavorable rating’ was invented.
Sounds like the perfect environment for a rally in U.S. stocks and bonds!
Despite increasing global economic and political uncertainty, U.S. stocks (as measured by the S&P 500 Index) recently hit a new all-time high. Within a few days of that milestone, the U.S. 10-Year Treasury also hit the lowest yield on record (bond prices rise as rates decline).
Given the global uncertainty, it is not a surprise that U.S. bond yields have dropped. Historically the U.S. Treasury market has been a safe-haven for global investors. As uncertainty rises, investors become more risk averse and seek out safer investments. And despite the economic challenges the U.S. is facing, our debt is still considered one of the safest investments in the world.
But ‘uncertainty’ itself does not fully explain a record-setting decline in U.S. Treasury yields. Another key reason for the decline is the fact that U.S. bonds are paying higher yields than comparable bonds from other developed nations.
As of this writing, the yield on 10-Year U.S. Treasuries is approximately 1.4%, while comparable bonds issued in Germany and Japan have yields of approximately zero. In fact, a recent study by Citi Research showed that approximately one-third of all developed-country government debt is yielding zero percent or less.
But why would there be a rally in U.S. stocks at the same time? Historically, stocks and bonds don’t tend to move in the same direction, let alone hit record highs concurrently.
First, economic growth in the U.S. may be low, but the prospects for economic growth look brighter in the U.S. relative to the rest of the developed world. This has led to a large amount of global investment directed to the U.S. It is no coincidence that the new high experienced in the stock market occurred shortly after the Brexit announcement. It was just one more reason U.S. investment looked more attractive relative to other developed markets. (Although a string of positive economic reports definitely helped.)
But another reason U.S. stocks are doing well is similar to why U.S. bonds have done well: the search for yield. Historically low interest rates around the world have led some income investors to purchase stocks instead of bonds. The 2.1% dividend yield on the S&P 500 Index becomes more attractive when rates on bonds are so low.
This has also led to rallies in high dividend-paying sectors of the U.S. market that are perceived to be safer than the market as whole. For example, the best performing S&P 500 industry sectors so far this year are Telecommunications and Utilities. It is no coincidence that these sectors have the two largest dividend yields in the index (4.3% and 3.3%, respectively).
There is no question that these are unusual times. Events in the world are obviously unpredictable, but the financial market’s response to a given event is even more unpredictable. That is why it is best to invest for the long-run, diversify, try to keep calm, and carry on.