Day Hagan Smart Sector® Fixed Income Strategy Update July 2024
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Day Hagan Smart Sector® Fixed Income Strategy Update July 2024 (pdf)
Risk Management Update
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity market. The model (Figure 1) held steady during June and entered July with a fully invested equity allocation recommendation.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index
Fixed Income Sector
US 1-3 Month T-bill
US 3-7 Year Treasury
US 10-20 Year Treasury
TIPS (short-term)
US Mortgage-Backed
US Floating Rate
US Corporate
US High Yield
International Corporate Bond
Emerging Market Bond
Outlook (relative to benchmark)
Neutral
Neutral
Neutral
Underweight
Neutral
Underweight
Overweight
Neutral
Neutral
Neutral
Fixed Income Commentary
Most central banks are becoming less hawkish, and many expect to start lowering interest rates. Of the 31 central banks we monitor, 27 are likely to decrease policy rates at their next meetings, with four remaining unchanged. It's worth noting that the Reserve Bank of Australia (RBA) is not expected to cut rates until the first quarter of 2025. Japan may raise rates as it aims to exit its zero-interest rate policy (ZIRP) and normalize its policy. This move would also support the yen, which has been declining and is close to its lowest level in 38 years.
The main question is how this will affect inflation. Our models and indicators indicate that inflationary pressures are still mildly disinflationary and, at worst, neutral. As mentioned in last month's update, stable economic growth and limited inflationary pressures are positive for equities. Improved equity performance is also favorable for corporate bonds. When we factor in a more accommodative stance from the Fed and other global central banks, the downside risk is reduced.
While there has been talk about the possibility of a Fed rate hike, current data suggests that the probability is very low. Overall, the percentage of central banks that have recently decreased their rates is increasing, and based on current expectations, it's likely to exceed 50% (Figure 2) soon. This is a positive factor for fixed income. Historical data shows that during periods of rising U.S. economic growth and neutral inflation, the U.S. Aggregate Bond Index has only gained at a modest annualized rate of +3.5% since 1972. In stable economic growth and neutral inflation periods, the gains were better at +10.5% on average, though such conditions were only present 8.5% of the time, offering a somewhat limited perspective.
Fixed income generally performs well during periods of economic weakness, stock market volatility, moderate disinflation, and around crisis events, both financial and non-financial. While global economic growth remains positive overall, there are indications of a slowdown. Our expectations for global economic growth are decreasing, with rising unemployment and consumer credit delinquencies, slowing home sales, an inverted yield curve, and exceptional corporate earnings growth limited to only a few companies. Additionally, inflation pressures are currently neutral, and geopolitical risks are elevated. All of these factors contribute to muted market volatility until conditions change.
In the longer term, fixed-income trends will depend on whether rates respond more to 1) reduced inflation expectations and slower economic growth (a positive for bonds as interest rates decline) or 2) ever-increasing levels of supply due to high sovereign debt levels and budget deficits, which could be negative for bonds. The policy responses to the pandemic (fiscal and monetary) continue to impact the markets, leading to persistent inflation and arguably keeping rates higher for an extended period. This has influenced expectations, particularly in the U.S., where investors initially anticipated seven rate cuts for the year, but that prediction has now been reduced to just one. Despite these recalibrated expectations, equity markets have shown resilience, and our risk model remains favorable.
Figure 2: Breadth of Central Bank Rate Changes
Sector Commentary
Treasuries: The composite model rates inflation expectations as disinflationary, with momentum measures, equity market trends, and U.S. Swaps as neutral. The U.S. Citi Economic Surprise Index turned negative in early May and has continued to retreat lower, indicating that economic reports over the past three months have been coming in below expectations. This has spurred discussion around a “soft landing” rather than “no landing.” A soft landing would be constructive for fixed income.
Figure 3: U.S. Economic Surprise Index
TIPS: We are currently underweight TIPS as inflationary pressures continue to moderate. The indicator evidence is mixed, with measures of inflation expectations, credit spreads, and trend (based on slope reversals) neutral. Commodity price trend indicators are still on a buy but have retreated, and any further weaknesses would flip the signal to a sell. Indicators calling housing trends and input prices (PPI) have moderated. Overall, the Inflation Timing Model remains in the “Moderate Disinflation” zone.
Figure 4: Since 1962, when the Inflation Timing model signaled moderate disinflation, the CPI Index has declined at a 1.0% annualized rate.
U.S. Mortgage-Backed Securities: The Composite model is mixed, with trend indicators rolling over and inflation expectations now neutral. During periods of low interest rates and strong housing markets, MBBs have performed well, providing higher yields than Treasury bonds while benefiting from the housing sector’s robustness. In contrast, MBBs not guaranteed by GSEs can suffer due to increased defaults on underlying mortgages during economic downturns or the housing market collapses.
Figure 5: Mortgage-backed spreads are ticking higher, though still below the long-term average.
U.S. Floating Rate: As described earlier, economic surprises this year have generally been to the downside while inflation pressures are neutral. However, the sector model shows that technical momentum and option-adjusted spreads have turned negative. The net result is a neutral exposure relative to the benchmark.
Figure 6: Momentum for U.S. Floating Rate Securities is negative.
U.S. IG Corporates: Technical cross and mean reversion factors are positive contributors to the model. Implied volatility, option-adjusted spreads, and the strength of the U.S. dollar (improving from negative) are neutral. An increase in Credit Default Swap rates is negative. The net result is an overweight position.
Figure 7: Relative Strength is improving from recent lows.
U.S. High Yield: High Yield correlates well with small-cap stock trends. Small-cap stocks’ performance has been relatively negative in June, with equity market breadth diverging. The investment model rates trend and breadth as bullish, with lower equity volatility and supportive credit spreads. We are neutral.
Figure 8: The Small-cap equity trend factor has reversed to a sell signal.
International IG Corporate Bonds: The model remained weak entering July, with several technical and external factors at negative levels. Measures of trend, relative strength, and inflation expectations are headwinds at this time. Regional exposure for the index shows 57.6% of the holdings are from Europe and 19.7% from the Pacific region (credit quality shows 78.9% rated A or better). With the ECB cutting rates and expected to cut more over the course of the year, we will monitor the technicals for signs that the trend is reversing back to positive. We are neutral at this juncture.
Figure 9: Inflation trends are moderating globally.
Emerging Market Bonds: The EM bond model declined entering July. Measures calling currency trends, emerging equity momentum, trend, and commodity market strength turned negative. We are now neutral.
Figure 10: Emerging Market equity momentum has rolled over. We have reduced exposure in response.
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.
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Smart Sector® Fixed Income ETF
Symbol: SSFI
Disclosures
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. Day Hagan 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. Day Hagan 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.
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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. Day Hagan 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.
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