By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
There are a few important spread indicators in the fixed income market that equity investors can monitor for periods of time when they should be cautious. History suggests that U.S. Federal Reserve (Fed) policy mistakes leading to an inverted yield curve either aided in the creation of or directly precipitated almost every U.S. recession and the majority of related large equity market selloffs over the last 100 years. Another useful indicator to monitor is the spread on corporate bonds, which increases as confidence in credit ratings decreases and the cost of debt rises. While these statistics can provide important insight to the possible timing of an economic slowdown, we do not believe they are signaling an impending equity market selloff. Since the Fed began their recent tightening cycle, the yield curve has flattened to some degree, however, credit spreads remain below their long-term averages. This suggests to us that there are more economic gains left in the current cycle, though the potential risks are heightened at this point.
THE YIELD CURVE
The yield curve is perhaps the best predictive indicator to an economic slowdown. While the Fed influences the short-end of the curve, the long-end is reflective of investors’ expectations for economic conditions in the future. The Fed has begun slowing the economic expansion by increasing rates on the short-end, which lessens liquidity and the profitability of lending. All the while, long-term rates have not increased much since the expectation for future economic growth is not getting better. At this point, the yield curve has flattened and may even become inverted if the Fed makes a policy error by going too far, too fast in rate hiking and misjudging the amount of liquidity in the market. An inverted yield curve is therefore a leading indicator that we can monitor for an impending economic slow-down. While the economic impact of an inverted curve is usually felt several quarters after inversion, we usually start to experience volatility to the downside in equity markets sooner.
Term spread is a useful way to monitor the Treasury yield curve as it reflects the differences between short-term and long-term rates. While the curve has flattened since the Fed began its tightening cycle, it has not inverted at this point.
CREDIT SPREADS
As a compliment to the yield curve, which reflects the difference in yield attributable to duration, credit spreads measure the difference in yield attributable to credit risk. These spreads are helpful in gauging investors’ expectations for future profitability. For instance, if investors believe the economy will continue growing and companies will be more profitable than they are today, they may not require a company pay them a high interest rate to borrow their money. Conversely, if investors are not as confident about the future economic environment and/or corporate profitability, companies will have to compensate them more for borrowing money. At this point, credit spreads remain below their historical averages, however, high yield spreads are showing a slight uptick. If rates move higher or we start to start to see a slowing trend in GDP, high yield and investment grade credit spreads will likely increase. If those spreads rise, it would signal that the market is losing confidence in their current ratings due to compromised ratios as the cost of debt increases with interest rates or that profitability is expected to slow.
We remain aware of the risks as the curve has flattened and credit spreads will likely increase from here. How bad it gets will depend on whether or not GDP growth is sustainable and can support higher long-term rates as the Fed continues on its tightening path. Further rate hikes amid a pick up in the reduction of the Fed’s balance sheet is a headwind to future economic expansion. Importantly, recent inflation data is likely to suggest to the Fed that they can escalate the pace of future rate hikes. If these hikes work to offset potential growth from expansionary fiscal policy, we would start to see the yield curve flattening trend continue and long rates move back down from their current levels.
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In this market environment, we think investors should look towards variable rate bonds, preferred stocks as well as target an intermediate duration in their core fixed income allocations. Variable rate bonds can benefit as the Fed raises interest rates on the short-end of the curve. Meanwhile, without the threat of significantly higher long-term interest rates, preferred stocks can generate attractive current yield. Lastly, we think that intermediate duration bonds are attractive as the Fed raises short-term rates and the yield curve flattens.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.