With a record short in US Treasury bonds two weeks ago, bond yields are still driven by rate expectations, not the ‘bond vigilantes’, as last week proved. The US employment report showed the first cracks in the so far impeccable picture, and bond yields followed suit by retreating from their 15-year highs. This happens when a trend change meets heavily skewed market positions. Stocks followed by rallying thereafter. Yet it is quite telling that the bond market went first again making this setback in stocks quite different from any other.
Year-end rally in equities has started
The S&P 500 and several European equity markets confirmed a buying thrust on Friday (3 November), where more than 90% of their members moved into a short-term uptrend. On top of the short-term improvement, the starting point is favourable, as the medium-term breadth remains depressed. Historically, a buying thrust combined with an oversold medium term reading has triggered a rally of 20% in the S&P 500 for the following 52 weeks.
The improvement is confirmed by the sector performance as well, as defensive sectors continue to underperform. Thus, large-cap growth stocks and selective mid- and small-cap stocks are the most likely to perform the best. Global interest rates have likely peaked as well for the coming six months. The US 10-year Treasury yield has fallen below its 10- week moving average, after being 24 weeks above it – the second-longest uptrend since 1982.
US economy: Cooling activity calms rate fears
A less tight labour market and signs of weaker-than-expected services activity have boosted confidence that the Fed has completed its rate-hike cycle, in our view. Nonfarm payroll gains in the US were much weaker in October, reversing the strong gains in September, which had been revised down slightly. At the same time, the alternative household survey, which also includes the self-employed, showed a sharp decline in employment, which led to an increase in the unemployment rate to 3.9%. The general normalisation of the labour market following the exceptional tightening is therefore continuing, and is helping to reduce the upward pressure on wages. This is an important relief for the Federal Open Market Committee, which had been watching carefully for signs that increased inflation could trigger a wage-price spiral. A cooling labour market and more moderate wage growth reduce this risk.
Global high yield: Improved valuation but not sufficient yet
Bond markets have shown some remarkable swings and twists so far this year. One of the interesting features, specifically in the second and third quarters, was the sharp tightening in credit spreads amid a better-than-feared economic backdrop and the resulting outperformance of riskier segments.
It was only after the summer break that we finally started to see some weakness in highly leveraged companies, taking account of increased refinancing risks. However, average metrics can be quite misleading in a credit portfolio. After all, the performance of such a portfolio depends on how many credit events occur, and there still seem to be enough companies in broader high-yield indices that are not well equipped for the new world of higher costs of capital.
Unprofitable and highly leveraged companies will face more difficulties in refinancing in the first place, or they may be forced to finance at much higher rates, which will put more pressure on their cost structure and, ultimately, their balance sheet over the coming months. As such, we expect the default rate to continue to pick up and regard improved valuations following the summer break not (yet) sufficient to reverse our Underweight rating for global high-yielders at this point. The alternative of higher quality debt is just too promising at this point.
Which segments will benefit the most from a year-end rally?
As bonds have been the epicentre, ‘bond proxies’ in stocks (i.e. companies with the most stable business models) have suffered overproportionately in the past 18 months. Thus, some relief in sectors like food, utilities, and real estate would be a logical first move. However, we see more potential in the most oversold equities for the weeks ahead (i.e. small and mid-caps), particularly in the US, where they were the most battered (their more fragile balance sheets make them more sensitive to rising rates). Meanwhile, the good news is that the tide will likely lift all the boats.