Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update March 2023
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Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update March 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 improved from last month and entered March 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: U.S. Stock/Bond Relative Strength Favors Equity Exposure
Stronger breadth and relative strength drove the model improvement. On February 2, a breadth thrust signal (10-day advances vs. 10- day declines) flashed bullish and the stock/ bond relative strength’s short-term moving average rose above its long-term moving average (chart left). In terms of external influences, improvement in short-term stock market sentiment was offset by deterioration in high yield and Emerging Market bond breadth.
For now, the weight-of-the-evidence recommends a fully invested allocation to fixed income sectors according to the model.
Fixed Income Market Update
After a 3% gain in January, the Bloomberg Barclays U.S. Aggregate Bond Total Return Index dropped by over 2.5% in February. The index has been positive for only four of the past 12 months. Of the nine fixed income sectors we track, all of them except cash had negative returns in February.
While the Fed acknowledged improvement in inflation at the February meeting, what is still in doubt is the pace at which inflation will continue to moderate and whether any progress on it will be sufficient for the Fed to loosen monetary policy. Following the January CPI and PPI reports and strong retail sales, yields backed up, the U.S. dollar rose, and markets pushed off expected rate cuts into 2024.
While goods inflation has come down significantly, services inflation has not. Amid broad-based inflation, the focus should be on the labor market and wage growth (chart below). Persistent strength in the latter, particularly if productivity growth remains weak, will continue to put upward pressure on unit labor costs and inflation. All of this suggests that the road back to 2.0% inflation will be bumpy, and it may take longer than anticipated. We currently expect two more rate hikes this year before the Fed pauses to evaluate the impact of cumulative tightening.
Entering March, the fixed income allocation strategy is overweight Floating Rate Notes, U.S. High Yield Bonds, and International Investment Grade, while Emerging Market Bonds, Treasury Inflation-Protected Securities, Mortgage-Backed Securities, and U.S. Investment Grade Corporate are underweight.
Figure 3: Wage Measures in Goods-Producing Industries
Floating Rate Notes’ allocation rose sharply in March, moving from the largest underweight to the highest overweight position. Floating rate notes typically outperform during a rising rate environment—yields across the board backed up in February. Trend, relative price momentum (chart right), and spreads turned bullish for the sector.
Figure 4: U.S. Floating Rate Notes Technical Momentum Improving: Bullish for the Sector
Figure 5: Improving Relative Strength is Bullish for International Investment Grade
International Investment Grade bond allocation rose, moving it from an underweight to an overweight. The majority of fundamental and technical indicators, such as improving relative strength (chart left) are now bullish for the sector.
Allocation to High Yield bonds declined a bit in March but remained overweight. While technicals, the small-cap equity trend, and sentiment measures were bullish for the sector, breadth (chart right) and absolute price moved bearish.
Figure 6: High Yield Bond Sector Breadth is Bearish.
Figure 7: Stronger U.S. Dollar is Bearish for Emerging Market Bonds
Emerging Market (EM) bonds’ allocation dropped sharply in March, moving the sector from an overweight to an underweight. The main culprit was the U.S. dollar rally in February. Due to the inverse relationship with Emerging Markets, a stronger dollar relative to EM currencies is a bearish condition for both emerging market equities and bonds (chart left).
The model’s allocation to U.S. Investment Grade Corporate saw a sharp drop in March, which pushed it from the largest overweight position to an underweight allocation. Three of the six indicators changed last month—the stronger U.S. dollar (bullish for the sector) was more than offset by widening spreads (chart right) and weakening technicals.
Figure 8: Widening Option-Adjusted Spreads is Bearish for U.S. Investment Grade Corporate
Figure 9: Weakening Relative Strength is Bearish for U.S. Mortgage Backed Securities.
Mortgage-Backed Securities’ allocation dropped sharply, moving it from a modest overweight to an underweight position in March. With mortgage rates rising during February, four of the six indicators are now bearish for the sector. All three technical measures are bearish—the relative strength moving average cross indicator (chart left) joined the other two this past month.
Summary
With yields across the board rising in February, fixed income sectors suffered. Floating Rate Notes and International Investment Grade improved to overweight, while U.S. Investment Grade Corporate bonds dropped to underweight. Additionally, a rising U.S. dollar led to Emerging Market bond underperformance and an underweight allocation.
NDR Strategists contributing to this publication: Brian Sanborn, CFA, Ed Clissold, CFA, Rob Anderson, CFA, Thanh Nguyen, CFA, Tim Hayes, CMT, Joe Kalish
For more information, please contact:
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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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