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The Case For Bonds Over Stocks Is Building -- ICYMI

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The market was closed Friday, but that doesn’t mean numbers weren’t moving. 

The consumer price index read -0.4% for the month of March, representing deflation. Subtracting energy and food prices (the core index), inflation was negative 0.1%. That’s for the month compared to March 2019. Coronavirus lockdown measures didn’t pick up in a material way until mid-March, leaving many economists and macro investment strategists to note that March economic data, while bleak, doesn’t show the full recessionary picture the U.S. is bound to see in the near-term.

Still, stocks have rallied

By mid-March the S&P 500 had fallen 34% from its all-time-high hit in mid-February, pricing in a recession. The equity risk premium -- the excess rate of return expected on stocks for the next year compared with the return on the 10-year treasury bond -- hit 7%. Historically, the premium sits at around 3% in expansionary environments and can touch around 10% before recessions. 

But stocks have rebounded from that 2020 low to the tune of 25%. Treasury yields, currently pressured by much needed Federal Reserve stimulus, have crept up. The 10-year yields are a touch above 0.7% now, as investors have sold the bonds. 

The virus news flow has grown incrementally more positive, with trends out of Europe and Asia showing a flattening infection spread curve. The Fed’s stimulus, coupled with Congress’ $2 trillion -- and potentially more on the way -- CARES Act may help households’ and businesses’ liquidity for the time being, potentially aiding a post-virus recovery closer to V-shaped, rather than U-shaped. 

But risks certainly remain and the inflation data out Friday may be the kicker for the pessimistic investor ready to pile into safety. 

First off, the virus is said to be reaching peak spread in New York this weekend. Before the world starts feeling social, many will recognize the U.S. is not out of the woods yet. That may mean continued economic hardship. JPMorgan economists are now projecting a second-quarter GDP collapse of 40%. Moody’s economists are more optimistic. They’re looking a GDP decline in the second quarter of 7%, worse than in the Great Recession. 

Secondly, the speed with which added liquidity gets into the hands of parties in the economy remains to be seen, leaving some, probably many people and businesses facing the possibility of bankruptcy in April. 

On inflation, yes, the negative reading is bound to go more negative in the short-term. Also, the consumer represents roughly 70% of U.S. economic output, indicating that the other 30% needs to be quite strong in order to lift price growth out of negative territory. 

Economists at Morgan Stanley do say they look for “disinflation, not deflation,” in a note recently published. They look for near-term inflation of roughly 1.6% because the goods sector will deflate, but the services sector, which represents roughly two-thirds of output will see the U.S. through. But it’s important to note that the U.S. saw 1.7% inflation for all of 2019, well before the virus broke out. 

Against all of these risk factors is an equity risk premium now at 4.9%, high compared to most years, but low compared to the period just before a recession. Sure, bear markets precede recessions and bull markets begin before recessions end and this isn’t yet expected to be a lengthy recession, like the Great Recession was. But the element of uncertainty brought on by the virus, which may come back after it initially fades, is one that must be considered. 

Stocks are also pricing in a double-digit percentage drop in 2020 earnings, compared to January forecasts, while several of Wall Street’s largest institutions are home to strategists that say the drop could be as severe as 40%. And that’s before one even considers the many factors that should pressure 2020 earnings multiples. 

Meanwhile, some of the safest bonds yield almost 1%, against what could easily be near-term deflation. 

Even for investors who want to avoid another equity market sell-off in the near-term and then go into the market with a war chest of cash, the 3-month treasury bill offers both a 0.23% yield and a supreme liquidity profile (it’s not volatile and matures soon). 

Many on Wall Street have recently advocated for investment grade corporate bonds, which are currently seeing price support by Fed buying and have yields better than those in the treasury market. 

Of course, the risk with “risk-free” assets (IG bonds aren’t in that class) is missing out on big gains in risk assets. 

Another risk: Negative interest rates. 

But Edward Jones Investment Strategist Nela Richardson put that to bed when she told TheStreet "I think the Fed is going to shy away from negative rates.” 

"The banks are really the tool that the Fed is using -- it's their wrench to get that credit to main street and if you hamper the banks by lowering rates to negative, you lower their net interest margins. It's going to be very difficult for the banks to serve its function." 

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