We have entered an age of idiots. So why aren't markets getting more nervous?
The war of words on the weekend between U.S. President Donald Trump and North Korean dictator Kim Jong-un – You're a dotard! Well, you're short and fat! – demonstrates that it may no longer be possible to reliably distinguish between conclaves of global leaders and a typical high-school lunchroom. Add in a Saudi Arabian coup, rising autocracy in China and an aging, expensive bull market in the United States and you might think that global risk indicators would be flashing red.
Instead, they're only flashing yellow. Many experts don't seem all that concerned and stock markets are largely taking matters in their stride, dipping only slightly over the past week.
"Perhaps the most likely explanation [for the mild sell-off in global stock markets] is worries about valuation," Oliver Jones of Capital Economics says. He thinks further stock market gains, especially in the United States, will be limited, but sees little reason to worry about any bigger, broader downturn until 2019, when he expects the U.S. economy to slow.
He may well be right. But smart investors should keep an eye on two key gauges of stress.
The single most worrisome one is the rising yields on junk debt – that is, the high-yield bonds issued by companies that don't qualify as investment grade. The SPDR Barclays Capital High Yield Bond ETF, a major buyer of low-quality debt, has slumped in price over the past week. Since bond prices move in the opposite direction to yield, the slipping value of the ETF indicates that investors are growing increasingly wary of holding onto dicier debt and are demanding higher yields to do so.
If this trend were to continue, it would be bad news for a multitude of companies. In the years since the financial crisis, a broad swath of the corporate world has become addicted to vast quantities of cheap debt. For those companies, a sudden jump in the cost of borrowing would be agonizing. At the very least, the recent turmoil in bondland suggests investors of all sorts should be cautious. In the past, the high-yield bond market has offered a good reading on people's appetite for risk and has been a decent indicator of what lies ahead for the stock market.
Another worrisome indicator for stock investors is the yield curve, which charts the yield on bonds of equal quality against the time those bonds have to run to maturity. The yield curve normally slopes upward, with lower rates for shorter-dated bonds and significantly higher yields for bonds that mature many years in the future. The higher yield can be seen as compensation for locking up your money for longer.
An inverted yield curve – one where the normal pattern is flipped and shorter-term bonds yield more than longer-term ones – has often signalled recession ahead. It suggests many people are rushing to find a safe place to stash their money and thereby bidding up the price of bonds with a longer time to maturity. Even a flattening yield curve, where the gap between short-term and long-term rates narrows, has historically been cause for concern.
In recent months, yield curves have flattened dramatically in many countries. In Canada, for instance, the spread between the yield on a 30-year government bond and the yield on a 10-year bond has shrunk to less than 35 basis points – that is, you pick up only about a third of a percentage point of yield in exchange for locking up your money for an additional 20 years. The spread is about half what it was earlier this year, an unusually abrupt narrowing.
So why aren't observers growing more anxious? One reason is that there is no obvious trigger for a broader downturn. Unemployment in Canada and the United States is at multiyear lows. Economic readings in Japan and the euro zone have been encouraging. Even worries about an imminent slowdown in China have faded.
Psychology also plays a role. In a recent note, Jeremy Grantham, the widely followed co-founder of money manager GMO LLC, argued that stock-market valuations have historically not been an accurate reflection of future economic prospects. Instead, they have merely demonstrated whether current indicators are making investors feel comfortable.
Three factors – high corporate profit margins, low inflation and stable economic growth (even if it's low growth) – explain a big part of how much people have been willing to pay for stocks over the past several decades.
Of course, as Mr. Grantham points out, these factors don't make a lot of sense as a way to value shares. Profit margins, for instance, tend to revert to their long-term mean, so high profit margins right now say very little about stocks' future prospects.
But logic doesn't seem to matter. "Whether sensibly or not, investors love high margins and like stable growth, even if it's modest, and hate inflation," Mr. Grantham writes.
Right now, investors are getting exactly what they desire. So don't expect today's markets to suddenly sour. But keep looking at junk bonds and yield curves for clues about when they will.