The financial markets are in disagreement. The yields available on high-quality corporate bonds have dropped to generational lows, as fixed income investors embrace the idea that the US economy is caught in a deflationary trap. Meanwhile, stock markets are priced for perfection, as equity investors remain optimistic that the life-support operations provided by the Federal Reserve will ultimately reflate the economy and restore price stability.
Investors need to determine which view will ultimately win out and allocate their assets accordingly. All else equal, the deflationary argument calls for a highly-defensive asset allocation with minimal exposure to risk assets, while the reflationary case prescribes an aggressive allocation with little investment in high-quality bonds. A reasoned analysis on which way the dice will ultimately fall requires a comprehensive understanding of secular investment cycles through time.
Investors need to appreciate that the economy rotates around price stability or the rate of inflation that maximises the non-inflationary rate of economic growth, and at any given point in time, the economy is either moving closer to or further away from this Holy Grail. Meanwhile, secular trends in both bond and stock valuations are determined by the stage of the cycle in which the economy currently lies.
The stages of the secular investment cycle can be classified under four general headings – disinflation, deflation, reflation, and inflation. A disinflationary regime is characterised by falling inflation and robust growth, a deflationary regime is characterised by low and falling inflation alongside poor growth, a reflationary regime is characterised by rising inflation and strong growth, and finally, an inflationary regime is characterised by high and rising inflation alongside disappointing growth.
The historical evidence reveals that recessions are fewer and less severe in both disinflationary and reflationary regimes, while real economic growth is stronger. During the reflationary period between 1949 and 1968 for example, the economy spent just one month in eight in recession, while the annual rate of economic growth was 4.3 per cent. Meanwhile, during the inflationary period between 1968 and 1982, the economy spent almost 30 per cent of the time in recession, while real growth was just 2.5 per cent.
It is important to appreciate that the secular investment cycle should be employed as an important input to asset allocation, given its influence on asset prices and valuations. Both bonds and stocks perform well in a disinflationary environment as valuations rise with the latter outpacing the former over the period. Bonds excel in a deflationary environment as yields decline, while stocks perform miserably as valuations contract. Stocks exhibit robust performance in a reflationary regime as valuation multiples expand, while bonds do poorly as yields rise, and finally, both fare badly in an inflationary period as valuations fall, with stocks outpacing bonds.
As an input to asset allocation decisions, it is important to identify transition points in the secular cycle. In this regard, it is instructive to note that high-quality corporate bonds have led stocks, as the cycle transitioned from deflation to reflation, and once again, when the underlying regime switched from inflation to disinflation.
The historical record of the past one hundred years provides clear evidence of the corporate bond market’s ability to signal an impending regime shift ahead of time in 1920, 1947, and 1981. The yield on high-quality corporate bonds peaked in June 1920 at 6.4 per cent, and registered a lower high six months later, which signalled the end of the two-decade long bear market. The stock market’s inflationary bear market drew to a conclusion eight months later.
The yield on high-quality corporate bonds bottomed in April 1946 at 2.5 per cent, and registered a higher low thirteen months later, which signalled the end of a secular bull market that spanned almost three decades. The stock market’s twenty-year deflationary bear market came to an end two years later, and even though the ‘buy’ signal seems quite premature, the high dividend yield available on stocks alongside the modest decline in the major market averages in the intervening period, meant that equity investors who acted upon the call earned a positive real return.
The yield on high-quality corporate bonds peaked in September 1981 at 15.5 per cent, and registered a lower high the following February, six months before the stock market’s inflationary bear market hit bottom. Equity investors subsequently went on to enjoy the strongest secular bull market in stock market history.
The financial markets are currently enduring a tug-of-war between the deflationary fixed income view, and the stock market’s reflationary optimism. Unfortunately for equity investors, the weight of historical evidence indicates that the bond market leads the stock market at important turning points in the secular investment cycle.
The fresh generational lows in the yields available on high-quality corporate bonds suggest the stock market’s more than decade long deflationary bear is not over.
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