Explore Our investment Outlook
One issue hanging over financial markets right now is the apparent disconnect between the stock and bond markets. Our own assessment is that this binary right/wrong framing is short-sighted. There are valid reasons for the divergence.
To understand the debate, consider that for the last four or five months, stock and bond markets have been rallying together. Stocks have repeatedly made record highs while bond prices rise, and yields fall. The bond rally slowed in August, but the fact remains—stock investors appear to be optimistic about the ongoing recovery, while bond investors seem to be positioning for an economic slowdown.
This is striking because over the last several years, they’ve tended to move in opposite directions. That is, they exhibit negative correlation. For context, it’s worth pointing out that the correlation of stocks and bonds over the long-term is effectively 0%. There’s been little or no obvious connection between stock and bond movements over the long term.
So far, we’ve presented this as a binary situation, where one market must clearly be right and the other clearly wrong. For example, the bond market could be correct if the delta variant’s human and economic tolls disrupt the recovery. Or the federal government grinds to a halt over the coming debt ceiling negotiations. In those cases, then it may well be true that stocks have gotten ahead of themselves and will have to pull back.
On the other hand, the stock market could be correct. Bond investors could be failing to appreciate the rapid and sustainable rebound in corporate earnings and the ongoing recovery in the job market. If that turns out to be the case, then bond yields need to rise (and prices fall) to reflect these stronger economic conditions.
Rather than one or the other, we believe this is a classic “couples compromise,” where both are correct to an extent. We think the most plausible explanation is that economic growth might be low or slow going forward, but positive. This makes sense as we emerge from the depths of pandemic-related shutdowns, and the economy makes quick strides toward recovery. Now that the economy has achieved those early gains, it’s only reasonable for the recovery to enter a slower, more mature phase.
Corporate earnings, however, are growing at a much faster clip than the economy. This isn’t that surprising. Since 1990, corporate profits have doubled the rate of growth of gross domestic product. The reality is that corporate earnings are much more volatile than economic growth as a whole.
The punchline? The markets are clear in what they’re calling for—decelerating economic growth going forward but relatively stronger corporate earnings growth.
The recent surge in inflation dominates the short-term, tactical targets presented here in the three- to six-month horizon. We don’t believe inflation is likely to persist beyond the pandemic-induced disruptions to supply chains. Nevertheless, at present, higher inflation makes cash more attractive than bonds within our dedicated fixed-income allocations. At a high level, we remain neutral with respect to equities versus fixed income.
Vaccine rollouts and social distancing policies have helped developed non-U.S. markets rebound and begin to close the economic and corporate earnings gap with the U.S. We continue to monitor these relationships, and relative valuations and economic fundamentals change but for now we see little reason to favor one over the other.
We see opportunities in emerging markets as growth and vaccination rates begin to approach those of developed markets. In addition, valuations in emerging markets are attractive relative to developed markets. Because this is such a broad and diverse category, we will rely on our managers to add value through individual security selection while we evaluate whether the headwinds facing this segment will be transitory.
We maintain this overweight based on small-cap stocks’ attractive relative valuations. In addition, the level of interest rates and ongoing cyclical recovery suggest sustained U.S. growth going forward. This is positive for small companies because they tend to have less international exposure and are more directly tied to U.S. growth.
Our multi-component growth/value forecast recently touched a 20-year high in favor of value. The model—and our intuition—continue to favor value but by a smaller margin. The stage of the economic recovery, as well as relative valuations and the risk/reward for many growth stocks, are key to this overweight. But interest rates remain stubbornly low (favoring growth stocks), and market sentiment also has been moving in favor of growth.
We are underweight developed market government bonds around the globe because of their low yields, with a preference for inflation-linked U.S. and Japanese government bonds. Corporate bond yields, too, are comparatively low, emphasizing the importance of credit research and individual security selection. We favor emerging markets sovereign debt, which we expect to benefit from progress containing the virus, improving economic growth and low rates, and stimulative monetary policies in developed markets.
We maintain a strategic allocation to global real estate investment trusts (REITs) for their attractive yield, risk/reward and diversification benefits in virtually every target-risk portfolio we manage. The segment is highly differentiated by industry and geography, and we believe active management is crucial to identifying opportunities in this market. For now, we are content to maintain a neutral allocation to global REITs and allow our portfolio managers to add value through individual security selection.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
International investing involves special risk considerations, including economic and political conditions, inflation rates and currency fluctuations.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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