Investors Favor Bonds, Defensive Sectors During Volatile Week | Page 2 of 2 | ETF Trends

In the fixed-income markets, the yield curve continued to flatten–causing long-duration bonds to outperform short-duration credits. High-yield bonds fared the worst after the market shifted to a more risk-off temperament. Emerging markets sovereign and corporate debt appreciated again this week as emerging markets currencies, on average, improved and as investors viewed the risk/reward trade-off for emerging markets corporate credits as attractive.

GAIN: Active Asset Allocation

A volatile week that started strong on news of progress on U.S.-China tariffs between President Trump and President Xi. However, mixed messages about the trade situation from the White House—along with the arrest of a high-level Chinese business executive—drove equities lower for the rest of the week. Technical indicators also spooked investors: Major market indices are below their 50-, 100- and 200- day moving averages. That said, economic fundamentals continue to be supportive.

One positive area for equities is emerging markets, which have held up better than the domestic equity market lately. Other bright spots have been value stocks and dividend stocks. Small-caps continue to be weak, however.

In the fixed-income markets, rates fell significantly as expectations for future Fed rate hikes softened. Corporate credits came under pressure due to stock market weakness and a general lack of buying interest from large investors. Credit spreads are nowhere near where they were a few years ago, and we believe the selloff in credit is overdone.

PROTECT: Risk Assist

Market volatility increased significantly last week, with the CBOE Volatility Index (VIX) rising by around 28%. Our updated volatility forecast also came in higher than the previous forecast; consequently, we continue to monitor our allocations for how quickly we may increase the portfolios’ “risk-off” exposure.

SPEND: Real Spend

Global equities were down close to 4% last week, led lower by U.S. stocks (down 4.4%—the S&P 500’s third-worst weekly performance of 2018). In contrast, investment-grade bonds were up 0.8%. Longer-term Treasuries led the way in the bond market as rates plummeted. The yield on the 10-year U.S. Treasury note was down 14 basis points—its largest weekly decline since April 2017.

As stocks fell and bonds rallied, the return spread between stocks and bond narrowed. The one-year spread between global equities and investment-grade bonds is now nearly -3%–meaning bonds are outpacing global stocks over the period. However, the spread between U.S.-only stocks and investment-grade bonds during that time remains positive, at 2.5%.

As noted last week, recent comments from the Fed have reduced expectations about the likely number of Fed rate hikes in 2019. Investors currently predict just one rate increase next year. This development may provide a short-term boost for bonds, which have underperformed for the bulk of 2018. For example:

  • Broad-based investment-grade bonds are down 1% year-to-date—their worst showing since 2013.
  • Investment-grade corporate credits have returned -4.9% year-to-date—one of their worst years on record. For example, since 1983, the only worse year for the asset class was 2008 (-5%).

The Fed’s dovish tone of late has been driven in at least in part by signs that inflation appears to be under control. Indeed, data last week shows that wage inflation remains contained. Since the end of the third quarter, medium-term inflation expectations (as measured by the U.S. Treasury market) have fallen nearly 25 basis points to around 2%.

Horizon Investments is a participant in the ETF Strategist Channel.