Animal spirits in markets run the risk of traveling too far

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Roula Khalaf, Editor of the FT, selects her favorite stories in this weekly newspaper.

Now would be a good time for investors to temper their enthusiasm, just a little. This year started with the bulls in full control. US stocks are now up 4 percent, making this one of the strongest opening months of any year in the past decade.

Donald Trump’s re-election as US president has ushered in a new era of “animal spirits” among business executives, as former investor Stan Druckenmiller said this week. Chief executives are “somewhere between relief and dismay” at the election results, he told CNBC. Meanwhile, US banks are “walk the walk“, the CEO of JPMorgan told the crowd in Davos, when crypto is about to enter “a place for girls”, according to its boosters. (No, me neither. It makes sense, however, to indicate that prices are about to rise.)

HSBC maintains a positive outlook. Its multi-asset group this week described a “very good environment” for risky assets in the first half of this year – a situation it described as “Goldilocks on steroids”, a mental image.

At the risk of spoiling all the fun, some market watchers – including some optimists – are starting to panic. The first big reason is the global government bond market, which has had a shaky start to the year. This is not a bad thing at all – it shows the continuation of the miracle of American economic growth. But it also reflects the prospect that inflation will continue to stick and that the Federal Reserve will struggle to keep cutting interest rates — no matter how much Trump might like it. On the margins, it also suggests that asset managers are looking for relatively high returns to feed government funds.

Whatever your favorite story here, the bottom line is that bond investors got it wrong (again) and that falling prices drove yields up (again). The most important figure of all – the US 10-year yield – sits well above 4.5 percent. That marks a recovery in prices since mid-January but is still high enough to undermine the case for stockpiling.

Like my colleagues reported this weekUS stocks have reached their most expensive bond-related levels in a generation. It’s getting harder and harder to justify holding on to stocks when their expected returns relative to earnings have fallen so far below the risk-free rate.

Peter Oppenheimer, chief global equity strategist at Goldman Sachs, noted at an event held at the central bank’s London office this week that stocks had largely shrugged off the competition so far – mainly because confidence in and very strong growth. But that leaves bond funds now “vulnerable to rising yields”.

It is silly but nevertheless true that the size here depends on the round numbers, which serve as important psychological indicators for investors. The big test would be if U.S. yields hit 5 percent. At that point, one of two things would happen: the bond haters would go crazy and dump the bonds. other product pullbacks, or selling would intensify and every asset class would suffer. My strong opinion is the former.

We’re not quite there yet, but as Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, put it this week, “we’re still at a critical juncture”.

“We’re getting closer to a zip code where slightly slower growth and slightly higher prices become a dangerous combination for markets,” he said. As a result, he is skeptical that financial markets in general, and the highly concentrated US markets, which rely heavily on technology, can continue the extraordinary performance of the past two years. Shalett expects gains in US stocks of between 5 and 10% this year. That’s not bad, by any means, but it won’t be a repeat of the 20 percent performance in each of the past two years.

Another thing that raises alarm bells is the level of confidence itself, especially among retail traders. The American Association of Individual Investors reports that the sentiment of “float” in its latest monthly survey. Expectations that prices will rise over the next six months rose another 18 percent through January, the AAII said.

Even optimistic wealth managers, who advise many of these investors, have a hard time stopping them. Ross Mayfield, an investment strategist at Baird Private Wealth Management, told me this week that he believes in a bull market, although he has half an eye on bond yields, which have moved “higher and higher.” right without a clear reason”. But he sees rare signs that the uniquely American theme is catching on among his customers. “I’m starting to have questions about whether you need to exchange at all,” he said.

None of this is a reason to run for the hills and hide in the safest resources you can find. But the wind is still somewhat weak at these high levels and the possibility of slippage from the new administration of the American president is strong. Glassy-eyed hope rarely ends well, no matter how muscular Goldilocks is.

katie.martin@ft.com