Last week, both stocks and bonds rallied. Bond yields fell to an 11-month low, with the yield on the10-year U.S. Treasury hitting 2.44% as prices correspondingly rose. Meanwhile, stocks also advanced, hitting new closing high records.
The question now is: Can stocks and bonds continue to advance together?
As I write in my new weekly commentary, “Sticking with Stocks,” at current levels, traditional bonds look expensive and I continue to favor equities over bonds. Even as stocks move toward new highs, they still offer more relative value than bonds, and I expect them to outperform over the long run.
Though I don’t expect a big selloff in bonds, causing rates to sharply climb back up, I do expect interest rates to rise modestly in the second half of the year. Even a small rate rise puts bond holders at risk, and at current prices, I don’t think traditional taxable bonds, notably Treasuries, offer enough value to compensate investors for those risks.
On the other hand, given how low rates are today, the prospect of moderately rising rates shouldn’t be a significant threat to stocks. When long-term yields are significantly below the 4% threshold, as they are today and will likely be through at least early next year, multiples actually tend to rise along with rates. In addition, an environment in which both rates and inflation are well below their long-term average is a favorable one for stocks and is supportive of modestly higher valuations.
However, investors do need to recognize that while equity markets still look cheap compared to bonds, they are getting more expensive. The rally in stocks is pushing valuations toward the upper end of their historical range. Many of the large markets, notably the United States, are no longer cheap in an absolute sense.
That said, there are still a few markets that look reasonable priced and offer some relative value. For instance, of the major developed markets, Japan is by far the cheapest, and emerging markets also look reasonably priced, trading at a discount to their post-crisis and long-term averages.