Last year, stocks were up strongly while bonds struggled. However, this year so far, U.S. stocks have struggled to hold onto gains while U.S. bond yields have plunged.
Most recently, last week, stocks slipped as investors digested mixed economic data and U.S. small caps entered correction territory, and equities are now up only nominally year-to-date. Meanwhile, as stocks floundered, bonds continued to rally – a broad measure of the U.S. bond market is up around 3.5%. The yield on the 10-year Treasury note broke below 2.5%, a six-month low, thanks to several factors, including institutional buying and some evidence of sputtering global growth.
As I write in my new weekly commentary, given the sharp and “Grand Reversal” from 2013, many investors are wondering: “How should I be positioning for the long term?”
My answer: Stick with stocks. Despite the strong performance of bonds year-to-date, I remain cautious toward fixed income and advocate maintaining a long-term overweight to stocks. To be sure, stocks are no longer cheap – and I would continue to avoid the more expensive areas of the market such as small caps and social media – but they still look inexpensive relative to bonds, particularly given the recent drop in yields.
Based on current inflation expectations, real 10-year bond yields are less than 0.5% before taxes. In other words, for most areas of the bond market, investors are receiving very little yield for increasing risk. Should interest rates rise even modestly, as I expect they will this year, the recent gains will quickly evaporate. And given the current low level of yields, bond prices are simply more sensitive to rising rates than they typically would be.
The bottom line: Although I think yields will remain low relative to historical levels, current bond prices, particularly those for long-dated Treasuries, look stretched, particularly now that the U.S. economy appears to be shaking off its weather related woes. Municipals offer better value, but I see few areas of the bond market compensating investors for the current implied risk.
In short, I maintain a long-term preference for equities and still believe that investors exercise caution before adding to positions in bonds. You can read more about my equity and fixed income outlooks in my new Investment Directions monthly market commentary.
Sources: Bloomberg, BlackRock research