Stocks have remained resilient in the face of rising bond yields, leading many to believe that a bubble, particularly in AI-related stocks, is forming. However, the alternative explanation boils down to one word: productivity.
Productivity gains, which translate to more output for the same amount of work, have allowed for economic growth without significant inflation. This shift in the market’s perception—from viewing a strong economy as negative for stocks to seeing it as positive—is largely driven by productivity gains. However, some analysts remain cautious, noting that stock prices still appear overly optimistic.
Short-term productivity gains, particularly over the past year, have contributed to lower inflation as the economy became more efficient, especially as pandemic-related disruptions to supply chains were resolved.
Investors who anticipated that the Federal Reserve’s high interest rates would hamper economic growth were surprised to find that much of the economy remained unaffected. The stronger-than-expected growth prompted economists to postpone expectations for the first Fed rate cut, resulting in higher bond yields. Nonetheless, shareholders were undeterred, as the anticipated gains from higher profits outweighed concerns about prolonged high interest rates.
At a fundamental level, investors believe that there is untapped potential for growth, allowing for increased profits before the economy reaches a point of overheating and inflation becomes a concern.
Looking ahead, many investors are optimistic that advancements in new technologies, particularly AI, will lead to a sustained productivity boom similar to that experienced in the 1960s or late 1990s. While higher productivity typically correlates with higher interest rates, the stock market anticipates that the accompanying increase in profits will offset any negative impact on stock prices.
This story of shifting dynamics is evident across various segments of the market. Initially, stocks moved inversely to Treasury yields in the latter half of the previous year, reacting as yields surged to a peak of 5% on the 10-year note and subsequently receded. However, there has been a slight shift recently, with stocks demonstrating a tendency to move in tandem with yields, albeit to a lesser extent.
Cyclical sectors, which are particularly sensitive to economic strength, have seen stronger performance compared to more stable defensive sectors as rate expectations and bond yields increased this year. This marks a departure from the trend observed in recent years, where higher Treasury yields were viewed as a hindrance to economic growth, negatively impacting cyclical sectors while benefiting defensive ones. Investors are now placing bets on the type of growth they anticipate in the future.
In the credit markets, there is a notable willingness to invest in the riskiest corporate bonds. Despite an overall increase in yields, the spread over Treasurys for junk-bond yields rated single-B or CCC—indicating investors’ perception of risk—has decreased this year, signaling increased confidence in these riskier assets.
The current interpretation of higher Treasury yields as positive for riskier companies contrasts with the sentiment of the past two years when such increases were viewed negatively. Previously, higher yields were seen as detrimental to companies due to increased interest costs and potential economic slowdown. However, the current strong economy has shifted this perspective, with higher yields now perceived as indicating lower default risk for riskier companies, despite the accompanying rise in interest expenses.
Investors may be overly optimistic about imminent productivity improvements. While generative AI has shown promise and corporate investment in the U.S. has been bolstered by government subsidies, challenges with generative AI are becoming more apparent, potentially limiting its applications. If productivity gains fail to materialize, the Fed may need to intervene to prevent inflationary pressures.
Moreover, productivity improvements do not benefit all sectors equally. Smaller companies, particularly those with higher leverage, such as real estate and wind farms, face greater challenges due to increased financing costs. The Russell 2000 index, which tracks smaller companies, underperformed larger stocks as rates rose but saw a reversal as rates began to decline, mirroring the trend observed last autumn.
While last year’s productivity gains were driven by the reversal of pandemic-induced supply shocks, expecting a similar boost from an AI productivity boom may be overly optimistic. Assessing the impact of new technologies on individual companies and the broader economy is complex, and investors may be overly enthusiastic in their expectations. Nonetheless, this optimism is preferable to the formation of a bubble.