Stocks and Bonds Are Sending the Correct Signals

What does a post-crash, post-austerity, post-globalization global economy look like? As close to perfect as possible, based on how investors are pricing financial volatility, credit spreads and equity risk premiums. Or, a time for caution based on the flattening of the yield curve, when the spread between two- and 10-year U.S. Treasury note yields is the lowest in a decade.

It is possible that both signals are right. An explanation would go something like this: A narrowing yield curve normally indicates investors are less confident about the economy’s future pace of growth, and that real gross domestic product and inflation won't be much stronger. Although the economy is not about to fall into recession, it is close to the peak for this growth cycle.

The signals sent by risk assets aren't inconsistent. The Cboe Volatility Index, or VIX, reached an all-time low of 8.56 on Nov. 24, even as both investment-grade credit spreads and the difference in yields between investment-grade and high-yield bonds compressed to the least since before the global financial crisis. This is a true signal that the search-for-yield “risk on” party is far from over. But it would be a stretch to expect the gains of 2017 to be repeated in 2018 given the starting point of current levels, even if companies continued to enjoy double-digit profit margins on top of nominal GDP growth. In other words, we are close to the peak of the investment cycle.