Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update September 2023
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Day Hagan/Ned Davis Research Smart Sector® Fixed Income Strategy Update September 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 slightly from last month but entered September, recommending full model exposure to several areas sensitive to equity markets: U.S. High Yield, Emerging Markets, and U.S. Investment Grade.
Figure 1: Smart Sector® Fixed Income Risk Management Model
Figure 2: Weakening Global Market Breadth: Bearish for Equity Exposure
The model’s overall bullish position is driven by four of the seven (price-based) measures that remain positive for stocks. However, global market breadth weakened during the month and flashed a sell signal (chart left). While external influences such as trade and market sentiment remained bearish and neutral, respectively, 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 down less than 1% in August. Returns have been flat or negative for eight of the past 12 months. Breadth weakened—five of the nine fixed income sectors we track had negative returns in August—weakness in U.S. Treasurys again dragged down the Aggregate.
Bond yields have come a long way in a short period of time. Ten-year Treasury yields have backed up 100 basis points (bp) from their April lows. Nearly all of the rise has been due to higher real yields.
Over that span, the 10-year Treasury Inflation-Protected Securities (TIPS) yield has climbed 91 bp (chart below). Changes in growth expectations are the primary driver of real yields.
As the “soft landing” narrative has gained traction, real yields have risen. An increase in the supply of Treasurys also likely contributed to higher real yields. The market seemed surprised by the amount of issuance announced earlier in August. However, there was more planned issuance than had been anticipated for the current quarter, which was mostly due to timing, as less debt was issued in the prior quarter. Back in May, the Treasury had warned us that an increased coupon supply was coming.
At the Jackson Hole address, Fed Chairman Powell noted that the outlook for economic growth and inflation remains shrouded in uncertainty, mainly stemming from the unknown duration of policy lags and changing labor market dynamics. While a soft landing is more likely, Fed policy will remain restrictive, which will slow down economic growth in the coming year.
Entering September, the fixed income allocation strategy remains with a risk-on message and suggests no rebalancing from the month prior. The model remains overweight U.S. Treasurys, U.S. High-Yield Bonds, U.S. Investment Grade Corporate, U.S. Mortgage-Backed Securities, Emerging Market Bonds, and underweight U.S. Treasury Inflation-Protected Securities, and Floating Rate Notes.
Figure 3: TIPS vs Nominal Treasury Yields By Maturity
U.S. High Yield bonds’ allocation was steady in August and remains in an overweight position. While four of six indicators remained bullish, two flipped negative during the month—the VIX and the small-cap equity trend (chart right). However, the small-cap equity trend is hovering near its 3-month moving average, so this indicator might get whipsawed.
Figure 4: Weakening U.S. Small Cap Equity Trend is Bearish for U.S. High Yield Bonds
Figure 5: Weakening Emerging Equity Momentum is Bearish for Emerging Market Bonds
Emerging Market (EM) bonds’ allocation declined slightly in August. Four of the five indicators remained steady. Emerging Markets have a positive relationship with rising commodity prices. However, during the month of August, the short-term momentum of Emerging Market equities moved to a bearish level for the sector (chart left).
U.S. Long-Term Treasurys’ allocation was steady in August and remains the largest overweight position. While the sector’s trend and momentum remained steady for the sector, a few indicators changed during the month. The U.S. equity market trend and U.S. swaps moved neutral. Inflation expectations, which have been quite volatile this past year, flashed a bullish signal for the sector right before Powell’s Jackson Hole speech (chart right).
Figure 6: Lower Inflation Expectations is Bullish for U.S. Long-Term Treasurys
Figure 7: Rising Commodity Price Trends Approaching Bullish Levels for U.S. TIPS
U.S. Treasury Inflation-Protected Securities (TIPS) allocation was steady in August and remains a significant underweight position. TIPS typically outperform when inflation is high. All six indicators remain bearish for the sector. We expected inflation to fall pretty hard into the spring and summer months, which it has. However, commodity prices—led by energy—have bounced, which could soon provide a tailwind for the sector (chart left).
Summary
Entering September, the fixed income allocation strategy remains with a risk-on message and suggests no rebalancing from the month prior. The model remains overweight U.S. Treasurys, U.S. High-Yield Bonds, U.S. Investment Grade Corporate, U.S. Mortgage-Backed Securities, Emerging Market Bonds, and underweight U.S. Treasury Inflation-Protected Securities, and Floating Rate Notes.
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
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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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.
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