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Stock-market investors have been caught between two impulses — leaving them prepared for neither.
Money managers piling into defensive stocks have looked to gain exposure from a further rally in risk assets even as they were reluctant to take up a larger position in recession-tested government bonds, which have offered a shrinking level of income as yields slumped this year, according to Andrew Lapthorne, head quantitative equity strategist at Société Générale, in a Wednesday note. That shift, he said, has left market participants vulnerable to either a full-blown economic downturn or a more unlikely rebound in growth.
That was painfully highlighted in September when growth and quality stocks were pummeled alike, slamming investors who had piled into those so-called defensive equities as an insurance policy against economic jitters.
“Overall, equity investors appear to be both ignoring the probability that a recession will actually turn up, while at the same time remaining poorly positioned if we actually do get some economic good news,” wrote Lapthorne.
He pointed out the swiftness with which so-called defensive stocks fell when bond yields surged in early September underlined how investors who looked to take shelter in so-called quality and defensive stocks were taken aback by improving economic sentiment, which briefly sent the 10-year Treasury yield TMUBMUSD10Y, -2.94% up around 40 basis points from their recent lows in the first half of last month. At their expense, stocks which have low valuations based on measures like price-to-book, or value, surged.
Since then, bond yields have retreated from their peaks. The 10-year note yield TMUBMUSD30Y, -0.13% last traded at 1.599%, from a recent closing high of 1.899% on Sept. 04.
See: The Great Rotation: Can the value rally last?
At the same time, equities of all stripes are unlikely to emerge unscathed from a recession.
“Many argue that low bond yields justify higher stock valuations, but in a bear market all stocks tend to lose money irrespective of their relative cyclicality,” he said.
More broadly, the overall stock-market has mostly ignored the worrisome drop in government bond yields since the beginning of the year, a sign that debt investors were increasingly gloomy about the economy’s prospects.
“Investors are playing a game of chicken: hoping lower bond yields do not lead to a recession, but equally that the global economy remains sufficiently moribund to not cause bond yields to rise and negatively impact expensive defensive and growth stock valuations,” said Lapthorne.
The S&P 500 SPX, -1.91% is up around 15% year-to-date, while the Dow Jones Industrial Average DJIA, -1.96% is up nearly 12% over the same period, FactSet data show.
Stocks were under pressure on Wednesday as a weaker-than-expected reading in an indicator of manufacturing activity, and slowing employment growth, raised concerns that the impact of the trade war was washing up on U.S. shores.
Read: Dividend stocks attract investors as trade-war worries shake up markets
Check out: Bond yields aren’t going any higher, and if they do, stocks will crash, says James Bianco