During the fourth quarter of 2018, bond yields topped 3.2% before ultimately falling to 2.7% by year-end. Meanwhile, stocks were taking a bruising from the combination of slumping global growth, rising trade frictions, and a hawkish Federal Reserve.
Fast-forward a few months and stock prices have risen handsomely, with the S&P 500 generating a year-to-date total return of 12.5%, despite the approximately 5% drop in May. Meanwhile, bond yields have plummeted to 2.25%.
Falling bond yields have triggered fears of weakening economic growth or, worse yet, a potential recession, and have renewed the age-old question every time stocks are holding up when bond yields are slumping: "Who is smarter, the stock market or the bond market?"
In our view, this isn't really the right question to ask. Equity investors care about future corporate profits while bond investors care most about inflation. Both are impacted by the economic cycle, but soft inflation can be consistent with enough economic growth to generate rising profits. The last decade is a pretty good example of how the two can coexist, with S&P 500 earnings per share more than tripling over the last 10 years while the Fed has consistently undershot its 2% inflation target.
But for equity investors, what matters is what comes next. Or, more specifically, do falling bond yields amid stable-to-rising stock prices portend an imminent stock market downturn?
History suggests it does not.
Using month-end data for the S&P 500 and 10-year US Treasury bonds over the past 60 years, we have identified all six-month periods where stock prices have increased at the same time that bond yields have declined by at least 75 basis points. The average three-, six-, and 12-month S&P 500 returns following such stock and bond market "disconnects" has been 6%, 11%, and 18%, respectively (see chart). Admittedly, many of those periods occurred during the very dis-inflationary 1980s after Fed Chair Paul Volcker was credited with "breaking the back" of the hyperinflation experienced in the late 1970s and early 1980s. But the analysis and results don’t change very much when only looking at the post-1990 time frame. In fact, since 1990, investors have never lost money over a 12-month horizon. The worst 12-month return was a gain of 1%.
Average S&P 500 price performance following stock vs. bond "disconnects"
S&P 500 returns following six-month periods of both rising stock prices and rapidly falling bond yields (>75bps decline)
Jeremy Zirin, CFA, Head of Equities Americas, UBS Financial Services Inc. (UBS FS) David Lefkowitz, CFA, Sr. Equity Strategist Americas, UBS Financial Services Inc. (UBS FS) Edmund Tran, CFA, Equity Strategist Americas, UBS Financial Services Inc. (UBS FS)