Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update August 2023
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Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update August 2023 (pdf)
Risk Management Update
The risk management model (chart right) seeks to reduce exposure to fixed-income sectors most sensitive to equity drawdowns. The risk management model was unchanged from last month and entered August recommending full model exposure to areas most sensitive to equity markets: U.S. High Yield, Emerging Markets, U.S. Investment Grade, and Floating Rate Notes.
Figure 1: Smart Sector® Fixed Income Risk Management Model
Figure 2: Rising U.S. Stock/Bond Relative Strength: Bullish for Equity Exposure
The model’s steadiness is driven by five (of seven) internal (price-based) measures that remain bullish, including rising stock/bond relative strength (chart left). While external influences such as trade and market sentiment remained bearish, they’re offset by bullish readings from high-yield and emerging market bond breadth, as well as high-yield option-adjusted spreads. For now, the weight of the evidence recommends a fully invested allocation to fixed-income sectors according to the model.
Fixed Income Market Update
The Bloomberg Barclays U.S. Aggregate Bond Total Return Index was flat in July. Returns have been flat or negative for eight of the past 12 months. Breadth remained strong—seven of the nine fixed-income sectors we track had positive returns in July—but weakness in U.S. Treasurys dragged down the Aggregate.
As widely expected, the Fed raised the target for the Fed Funds rate by 25 basis points in July to a range of 5.25% to 5.50%, the highest since March 2001. The Fed has raised rates 525 basis points since March 2022, making it the fastest hiking cycle ever. The Fed also maintained its tightening bias and is keeping its options open with respect to another rate hike to underscore its commitment to fighting inflation.
Although central banks have different mandates and face different economies, they share a common inflation objective of 2%. While all policymakers look at a wide array of data in making decisions, none is more central than labor compensation. Wages are highly correlated with core inflation and are a good proxy for measuring inflationary pressures in the non-shelter services sector. The U.S. is making progress. Unit labor costs slid to 3.0% in Q2 from a peak of 6.5% in Q2 2022 (chart below), but it still has a way to go to get down to target.
If the data evolves as we expect, the Fed will likely skip raising rates in September. But the upside risks to inflation could lead to another rate hike in Q4. However, the markets, once again, appear to be underpricing the risk of additional hikes.
Entering August, the fixed income allocation strategy has a moderate risk-on message. The model is overweight U.S. High-Yield Bonds, U.S. Long-Term Treasurys, Emerging Market Bonds, and International Investment Grade Corporates. We are underweight U.S. Treasury Inflation-Protected Securities, Floating Rate Notes, and U.S. Mortgage-Backed Securities.
Figure 3: Unit Labor Costs For Industrialized Nations (Year-to-Year Changes)
U.S. High Yield bonds’ allocation rose over 500 basis points in July and is an overweight position. All six indicators remained bullish. External influences such as the small-cap equity trend (chart right), the VIX, and option-adjusted spreads continue to provide tailwinds for the sector. The three internal (price-based) measures of trend and breadth confirm the model’s positive message.
Figure 4: U.S. Small Cap Equity Trend is Bullish for U.S. High Yield Bonds
Figure 5: Commodity Market Strength is Bullish for Emerging Market Bonds
The Emerging Market (EM) bonds’ allocation is also an overweight position. Four of the five indicators remained steady. Emerging Markets have a positive relationship with rising commodity prices. During July, commodity strength improved to a bullish level for the sector (chart left).
The U.S. Long-Term Treasurys’ allocation is overweight relative to the other credit sector positions but underweight the benchmark. While the sector’s trend and the U.S. equity market trend remained bearish for the sector, a few indicators changed during the month. Momentum moved neutral, and U.S. swaps became bearish. Rising inflation expectations, a sign that investors believe the Fed tightening cycle may not be over just yet, also flashed a bearish signal for the sector (chart right).
Figure 6: Rising Inflation Expectations is Bearish for U.S. Long Term Treasurys
Figure 7: Weak Relative Strength Index is Bearish for TIPS
U.S. Treasury Inflation-Protected Securities (TIPS) allocation was steady in July and remains a significant underweight position. TIPS typically outperform when inflation is high. Since we have passed the peak in inflation, the sector has been under pressure. All six indicators remain bearish for the sector. The sector’s relative strength index (RSI) has been weak since early May (chart left).
Summary
Entering August, the fixed income allocation strategy has a moderate risk-on message. The model is overweight U.S. High-Yield Bonds, U.S. Long-Term Treasurys, Emerging Market Bonds, and International Investment Grade Corporates. We are underweight U.S. Treasury Inflation-Protected Securities, Floating Rate Notes, and U.S. Mortgage-Backed Securities.
This strategy utilizes measures of price, valuation, economic trends, monetary liquidity, and market sentiment to make objective, unemotional, rational decisions about how much capital to place at risk, as well as where to place that capital.
NDR Strategists contributing to this publication: Brian Sanborn, CFA, Ed Clissold, CFA, Rob Anderson, CFA, Thanh Nguyen, CFA, Tim Hayes, CMT, Joe Kalish
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Day Hagan/Ned Davis Research
Smart Sector® Fixed Income ETF
Symbol: SSFI
Strategy Description
The Smart Sector® Fixed Income strategy combines two Ned Davis Research quantitative investment strategies: The NDR Fixed Income Allocation and the NDR Catastrophic Stop.
The Process Is Based On The Weight Of The Evidence
The fund begins by overweighting and underweighting fixed-income sectors based on Ned Davis Research’s proprietary fixed-income models.
Each of the models utilizes sector-specific, weight-of-the-evidence composites of fundamental, economic, technical, and behavioral indicators to determine each area's probability of outperforming the other categories.
Sectors are weighted accordingly relative to an equal-weighted benchmark.
When Market Risks Become Extraordinarily High - Reduce Your Portfolio Risk
The model remains fully invested unless the Ned Davis Research Catastrophic Sell Stop (CSS) model is triggered, whereupon the areas which underperform during periods of market stress (high yield, Emerging Markets, U.S. Investment Grade, and Floating Rate Notes) are trimmed by 50%..
The NDR Catastrophic Sell Stop model combines time-tested, objective indicators designed to identify periods of high risk for the broad financial markets. The model uses price-based, breadth, deviation from trend, fundamental, economic, interest rate, behavioral and volatility-based indicator composites.
When Market Risks Return To Normal — Put Your Money Back To Work
When the NDR CSS model moves back to bullish levels, indicating lower risk, the strategy immediately moves back to fully invested.
Ned Davis Research Disclaimers
The data and analysis contained within are provided "as is" and without warranty of any kind, either express or implied. The information is based on data believed to be reliable, but it is not guaranteed. NDR DISCLAIMS ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY, SUITABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. All performance measures do not reflect tax consequences, execution, commissions, and other trading costs, and as such investors should consult their tax advisors before making investment decisions, as well as realize that the past performance and results of the model are not a guarantee of future results. The Smart Sector® Strategy is not intended to be the primary basis for investment decisions and the usage of the model does not address the suitability of any particular in Fixed Income vestment for any particular investor.
Using any graph, chart, formula, model, or other device to assist in deciding which securities to trade or when to trade them presents many difficulties and their effectiveness has significant limitations, including that prior patterns may not repeat themselves continuously or on any particular occasion. In addition, market participants using such devices can impact the market in a way that changes the effectiveness of such devices. NDR believes no individual graph, chart, formula, model, or other device should be used as the sole basis for any investment decision and suggests that all market participants consider differing viewpoints and use a weight of the evidence approach that fits their investment needs.
Disclosures
Past performance does not guarantee future results. No current or prospective client should assume future performance of any specific investment or strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals and economic conditions may materially alter the performance of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. There can be no assurances that a portfolio will match or outperform any particular benchmark.
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NDR is a registered as an investment adviser with the Securities and Exchange Commission (SEC). NDR serves as the Signal Provider in connection with this strategy. The information provided here has not been approved or verified by the SEC or by any state or other authority. Additional information about NDR also is available on the SEC's website at https://www.adviserinfo.sec.gov/. This material is provided for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or to participate in any trading strategy. NDR’s strategies, including the model discussed in this publication, are intended to be used only by sophisticated investment professionals.
There may be a potential tax implication with a rebalancing strategy. Re-balancing involves selling some positions and buying others, and this activity results in realized gains and losses for the positions that are sold. The performance calculations do not reflect the impact that paying taxes would have, and for taxable accounts, any taxable gains would reduce the performance on an after-tax basis. This reduction could be material to the overall performance of an actual trading account. NDR does not provide legal, tax or accounting advice. Please consult your tax advisor in connection with this material, before implementing such a strategy, and prior to any withdrawals that you make from your portfolio.
There is no guarantee that any investment strategy will achieve its objectives, generate dividends or avoid losses.
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© Copyright Ned Davis Research, Inc. All Rights Reserved | These materials are historical and intended to be used only as examples, and do not necessarily reflect current views or advice of NDR or its representatives.
