USING INTEREST RATE TRENDS TO IDENTIFY EQUITY TRENDS
With equity market volatility still relatively muted, I was recently asked what individual indicator I'm watching for signs that a more substantial decline may be in the works.
The key word here is "substantial." Most recently, investors have found reasons to buy dips, even if counted among those reasons is a fear-of-missing-out rationale. Nevertheless, historically substantial declines have been accompanied by compound financial market dislocations.
Therefore, while we subscribe to a quantitative, unemotional weight-of-the-evidence approach, I would say that for signs that a decline could move into the realm of substantial, I keep looking over my shoulder toward the credit markets as the potential canary in the coal mine. I view the credit markets as arbiters representing the final tally of billions of investors voting on such disparate issues as inflation, currency, crisis probability, central bank expectations, economic outlook, consumer confidence and so on.
It can be argued that lower interest rates and accommodative central bank policies encouraging (or forcing) investors to take on risk have carried a good portion of the current bull market. Importantly, the world has been awash with liquidity to support that risk taking. Our view is that a reversal from this bullish dynamic would be concerning.
A few significant bumps have arisen along the way, with an increase in yields within the less-than-investment-grade arena preceding or accompanying each. To illustrate this, we feature the chart below showing the S&P 500 in the top clip and an index of U.S. dollar-denominated corporate debt rated BB (which is below investment grade) in the bottom clip. (Exact description: BofA Merrill Lynch U.S. dollar-denominated, non-investment grade-rated corporate debt publically issued in the U.S. domestic market with a rating of BB.)
We have marked reversals in the High Yield Corporate Debt effective yield with arrows. As you can see, when yields have increased from low levels, the S&P 500 has typically experienced subsequent weakness. Conversely, yields reversing from higher levels has often marked a good time to add to equity exposure. Clearly, we have identified the exact turning points in yields with the benefit of hindsight. However, we were struck by how well the reversals in yields "called" or alerted investors to potential weakness or strength in the S&P 500. This indicator represents a proxy for how much risk premium investors demand. When yields move higher, investors demand more return for taking on the risk of owning those bonds.
We will only know the exact bottom of U.S. High Yield BB-rated Corporate debt in hindsight. But we do know that many interest rate structures remain near historical lows, artificially held down by the result of trillions of dollars of central bank injections. (In June, there was still over $9 trillion of negative yielding debt according to Fitch ratings. So no, the markets are not normal.)
We also know that our review of credit spreads in the U.S. and internationally continues to show that very little risk is being priced in. Our experience tells us that when levels are this compressed, once a reversal takes hold, it can move very quickly.
As Art Day recently quipped, "When did high yield bonds start yielding less than I got in my money market account in 2007?!"
It's not just U.S. rates that are low. The next chart illustrates the Vanguard Emerging Markets ETF (symbol: VWO) in black and the Emerging Markets High Yield Corporate Bond Index Effective Yield in red. Note the inverse relationship. We're watching this closely as well.
Lastly, we also monitor the St. Louis Financial Stress Index, which is near historically low levels. This composite is based on seven interest rate indicators, six yield spread indicators, volatility indicators and one indicator measuring the S&P 500 Financials Index. U.S. domestic and international indicators are included. It provides a broad-based view of financial market relationships and if they are behaving normally. You can see the increase from 2015 (a weak year for equities) into early 2016 when the S&P 500 hit multiyear lows. We think changes in direction for this model bear close watching as well.
Bottom Line: From a broader market perspective, we are on the lookout for changes and reversals in investors' perception of risk. Interest rate differentials are one spoke in our wheel of indicators, but an important one. These indicators are longer-term, and from this vantage, we conclude that investors are still very much in the "risk on" mode, and not yet responding to the stretched relationships, i.e., the historical extremes we're noting. Overall, our work continues to mandate a slightly bullish stance for equities while not throwing caution to the wind.
If you have any questions or comments, please feel free to email or call anytime.
Have a wonderful week,
Donald L. Hagan, CFA
— Written 9-1-2017
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The S&P 500 Index is based on the market capitalizations of 500 large U.S. companies having common stock listed on the NYSE or NASDAQ. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged, fully invested, and cannot be invested in directly.