The bond sell-off was triggered by the Federal Reserve’s spring announcement that it was prepared to reduce asset purchases (i.e., “taper”), but the fact was that bond yields had become irrationally low relative to fundamentals and a correction was just a matter of time. The question at the forefront of investors’ minds as we enter 2014 is whether the same thing is likely to happen to stocks, which have performed spectacularly well over the past several years.
Our answer is no, at least for the time being. Stock valuations are not unreasonable from an historical perspective, and we expect the supportive environment of moderate US growth and low inflation – along with a Federal Reserve that continues to try hard to boost both – to remain in place for the next few months.
But the bar for continued strong performance of stocks has become higher: corporate profit margins appear to be peaking and the equity risk premium – the excess of earnings yields on stocks to real bond yields – has shrunk significantly following the relative revaluation of the past year.
Moreover, considerably less fiscal tightening, huge gains in household wealth and less slack in the economy than is commonly perceived combine to suggest that both US growth and inflation should grind higher as we move through 2014. This suggests that Fed rate hikes could come into investor sights before the end of next year, triggering another leg down in bond prices, and threatening stock valuations as well.
All of this means that the clock is ticking for risk assets. With stocks not as cheap relative to bonds, we recommend a move toward better balance. Within fixed income portfolios, we advise investors to favor duration and stay away from short- and medium-term assets. We also recommend some hedging of long stock positions, as low volatility and higher long-term bond yields have made it more attractive.