I spy with my investor eye
Author: Kevin McCreadie
February 1, 2019
Equity markets have rebounded from the end-of-year rout that pushed the S&P 500 to the brink of bear market territory in 2018, but investors still face a number of challenges and should anticipate more volatility in the days ahead. Here are five ways to track the current state of markets and gauge the future direction of the economy.
Purchasing Manager Indexes
Purchasing Manager Indexes (PMIs) have long been a reliable gauge of economic health whereby scores of 50 or more represent expansion and scores less than 50 represent contraction. While a vast majority of countries around the world have PMIs that remain in expansionary territory to start the New Year, many have seen their scores weaken in recent months. Of the 18 PMIs that Strategas, an institutional broker/dealer, tracks regularly, there were only two (Japan and UK) in December with scores greater than 50 that had also strengthened from the month previous. That’s down from eight on Strategas’ November PMI scorecard.
The market’s fixation on the flattening U.S. yield curve has ramped up since the 5-year Treasury note temporarily fell below the yield on the 3-year note in early December. While this type of inversion isn’t the same foolproof predictor of recession that the 2-year note holding a higher yield than the 10-year note has been since World War II, it may be a sign that the market is headed in that direction – especially if narrowing spreads between short and long-term rates discourage future bank lending.
Credit spreads are usually a good proxy for the amount of risk that investors are willing to take and have been well worth keeping a close eye on in the current climate of volatility. As stocks prices swooned at the end of 2018, both investment grade and high yield spreads widened significantly, in part, because of slumping oil prices and the potential impact that may have on the energy sector, one of the major participants in North America’s credit market. More recently, however, spreads have begun tightening back to more reasonable levels and stocks have rallied sharply.
Mortgage-backed securities (MBS) were at the centre of the financial crisis a decade ago. Now, it’s leveraged loans and, in particular, collateralized loan obligations (CLOs) representing a potential risk to investors at this late stage in the economic cycle. At close to US$1.3 trillion, the institutional U.S. leveraged loan market has surpassed the U.S. high yield market in size and CLOs have grown substantially in recent years with new issuance hitting a record of US$130 billion in 2018, according to Bloomberg data. The growth has been fuelled by the ongoing hunt for yield, but is also marked by a steep deterioration in credit quality. About 29% of leverage loans issuers are now rated B3 (re: obligations are considered speculative and subject to high credit risk) compared to 14% a decade ago, according to Moody’s Investors Services data.
Institutional leveraged loans vs. high-yield bonds
Source: Barclays U.S. Corporate High Yield Bond Index; loan data compiled by Bloomberg LP. as of January 25, 2019. All figures in USD. “T” denotes trillions; “B” denotes billion.
Bonds rallied during the year-end stock rout, once again proving their worth as an important diversifier in tough market environments. But that isn’t always the case and when bonds and stocks both fall, investors need to pay extra attention. Take the selloff in both U.S. treasuries and U.S. equity market last February. Not only did traditional 60/40 portfolios have nowhere to hide, it forced a number of more sophisticated risk parity strategies – which tend to have outsized exposure to bonds — to deleverage and dump their investments into an already falling market. While it’s debatable just how big of an amplifier this additional selling was at the time, the growing influence of risk parity and similar strategies that utilize algorithmic trading raises the prospects of an exacerbated market disruption anytime stocks and bonds swoon in tandem over a prolonged period of time.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives.
The commentaries contained herein are provided as a general source of information based on information available as of January 28, 2019 and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies.
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