Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update October 2023
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Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update October 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 deteriorated from last month but entered October 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: Volume Supply Exceeding Demand: Bearish for Equity Exposure
The model’s overall reading is driven primarily by bullish external influences such as trade, market sentiment, and high-yield spreads. However, price-based measures have weakened during the month—three additional indicators flashed a sell signal including supply vs. demand (chart left). 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 down for the fifth month in a row, dropping 2.5% in September. Breadth remained weak—seven of the nine fixed income sectors we track had negative returns in September—significant weakness in U.S. Treasurys again dragged down the Aggregate.
Sticky inflation, rising oil prices, and tight labor markets have been pushing yields higher all summer. Economic growth is likely to slow in Q4 and in 2024 (due to student loan repayments, strikes, etc.), labor markets should cool and get back into balance, and impacts from credit tightening should be increasingly felt.
In September, the Fed surprised the markets by reaffirming its projection for another rate hike this year and indicating two fewer rate cuts next year, even though inflation was revised lower for 2023. The Fed successfully communicated a “restrictive for longer” policy stance.
The Fed’s policy projections had two important implications. One is the pricing in of higher rates at the front end of the curve due to a higher terminal rate than the market had been expecting.
Two is a steeper yield curve since yields will be higher next year than previously thought. As a result, yields broke out across the curve and around the world (chart below) while yield curves steepened.
As a result, entering October, the fixed income allocation strategy rebalanced and favored mixed leadership. The model is overweight U.S. Treasury (10-20 years), International Investment Grade, and U.S. High Yield. Emerging Market bonds were downgraded to marketweight, joining U.S. Corporates and U.S. Mortgage-Backed Securities. The model is underweight U.S. Floating Rate Notes and U.S. Treasury Inflation-Protected Securities.
Figure 3: Yields on Key Treasury Securities
U.S. Treasury Inflation-Protected Securities’ (TIPS) allocation rose over 300 basis points in September, though is still underweight. Similar to U.S. Floating Rate Notes, TIPS typically outperform when inflation is high (which then leads to higher interest rates). While inflation is down from its peak, there are still areas that are sticky. Commodity prices—led by energy—are rising and has provided a tailwind for the sector (chart right). This positive development was confirmed by two relative strength measures flashing bullish signals during the month.
Figure 4: Rising Commodity Price Trends are Bullish for U.S. TIPS
Figure 5: Rising Relative Strength: Bullish for International Investment Grade
International Investment Grade bonds’ allocation remains overweight. While global option-adjusted spreads and U.S. swaps remain neutral, equity volatility is bullish. This was confirmed by two bullish price-based measures including rising relative strength trends (chart left).
U.S. High Yield bonds’ allocation remained steady September, at an overweight position. Four of six indicators are now bearish, with two flipping negative during the month—absolute trend and breadth (chart right).
Figure 6: Weak Sector Breadth is Bearish for U.S. High Yield Bonds
Figure 7: Weakening Short-Term Trend is Bearish for Emerging Market Bonds
Emerging Market (EM) bonds’ allocation remains marketweight. On a fundamental basis, while rising commodity prices is bullish for Emerging Market bonds, weakness in emerging market equity momentum and currencies have been an offset. Technicals are mixed—relative strength remains bullish, but absolute trend moved to a bearish level for the sector during the month (chart left).
U.S. Investment Grade Corporate bonds’ allocation dropped over 200 basis points in September, downgrading the sector from overweight to an underweight position. Four of the six indicators are now bearish. While the U.S. dollar index and a mean reversion measure remained bullish for the sector, spreads, credit default swaps, and a trend indicator are bearish offsets. Additionally, implied bond volatility rose to a bearish level for the sector during the month (chart right).
Figure 8: Rising Bond Volatility is Bearish for U.S. Investment Grade Corporate
Figure 9: Weakening Momentum is Bearish for U.S. Long-Term Treasurys
U.S. Long-Term Treasurys’ allocation increased in September. While inflation expectations appear contained and have remained bullish for the sector since the Jackson Hole meeting, a few indicators changed during the month. The U.S. equity market trend, U.S. swaps, and sector momentum all flashed bearish signals during the month (chart left).
Summary
Entering October, the fixed income allocation strategy favors mixed leadership. The model is overweight U.S. Treasury (10-20 years), International Investment Grade, and U.S. High Yield. Emerging Market bonds were downgraded to marketweight, joining U.S. Corporates and U.S. Mortgage-Backed Securities. The model is underweight U.S. Floating Rate Notes and U.S. Treasury Inflation-Protected 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 and 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
For more information, please contact:
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Office Phone: (941) 330-1702
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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References to “NDR” throughout refer to Ned Davis Research, Inc. Clients engaging in this strategy will be advised by Day Hagan and will not have a contractual relationship with NDR. Day Hagan purchases signals from NDR, and Day Hagan is responsible for executing transactions on behalf of its clients and has discretion in how to implement the strategy.
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.
© 2023 Ned Davis Research, Inc. | © 2023 Day Hagan Asset Management, LLC
© 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.
