August 15, 2016

Market strength is surpising

It's been risk-on in 2016, although the journey has been a dramatic rollercoaster ride rather than a straight line.

And fixed income has been the the star of the show -- a dominating influence that brought us the notion of "TINA." (as in, "There Is No Alternative" to stocks).

But just as many see Woodstock as the 1960s' "the last waltz," I'd suggest that bonds' recent rising prices and falling yields might represent a last waltz for the stock market. Let's check out where we've been and where we might be heading.

Actin' Funny, But I Don't Know Why

The Dow industrials, S&P 500 and Nasdaq Composite all hit all-time highs on Thursday. Consider:

- The S&P 500 is now +21% from its Feb. 11 intraday low.
- The iShares iBoxx U.S. Dollar High Yield Corporate Bond ETF (HYG) is +14.2% from the February lows.
- The JPMorgan Global High Yield Index is +13.9% year to date on a total-return basis.
- The JPM CCC bond index is +23% on a total return basis year to date.

But amazingly, Treasuries and investment-grade bonds have also also rallied big-time even as this huge risk-on move occurred. Of course, the Bank of Japan, the European Central Bank and the Bank of England have all accelerated bond buying, while expectations for Federal Reserve rate hikes have plummeted. As a result:

- Treasuries have rallied, with the 10-year yield tumbling from a 1.66% peak on Feb. 11 to a 1.32% all-time low on July 6. The 10-year yield closed Friday at 1.51%.
- JPMorgan's Investment-Grade Bond Index is +8.9% year to date.

In fact, virtually every fixed-income sector is having a strong year. But with macroeconomic data generally slowing and corporate revenues and earnings on the decline over the past few quarters, it's hard to attribute a large part of bonds' success to anything other than global central-bank activity.

After all, you might recall that the markets actually had a risk-off move at the end of 2015 and into 2016's first quarter following the Fed's December 25-basis-point rate hike and global fears about China's economy.

This accelerated the U.S. dollar's rally and commodity prices' collapse (led by oil). As this chart shows, West Texas Intermediate tumbled to a $26.21 low on Feb. 11 after the dollar had surged:

But the greenback had clearly gotten way ahead of itself in pricing in a Fed rate hike. So, as the chart above shows, the U.S. Dollar Index had already begun weakening from its 100.17 high on Nov. 30 before WTI put in its eventual bottom on Feb. 11.

Add in a blowout in high-yield spreads and the S&P 500 bottoming out 15% below its May 2015 peak by February and we got a dramatic shift in rate-hike expectations. Fed chair Janet Yellen's March 29 speech to the Economic Club of New York only confirmed that she had no desire to raise rates quickly.

Check out this slide from a friend of mine. It shows the odds that the futures market was pricing in for Fed hikes as of Jan. 11, when the S&P 500 stood at 1,924 (some 14% below today's levels):

Whatever It Is, Those Banks Put a Spell on Me
British voters' unexpected decision on June 23 to back a Brexit ultimately saw just two sessions of risk-asset selling. Literally two:

- The S&P 500 sold off 5.4% between the close on Thursday, June 23 (before the results were known) and the close on Monday, June 27, two sessions later.
- High yield probably dipped three points on the higher-beta side, while WTI fell by more than 7.5%.

Even for those of us who thought the vote was hardly global economic disaster, the fact that the correct course would have been to wave in any and all financial assets since Monday, June 27, is rather unbelievable.

It's true that the Brexit vote was a huge surprise, but it enabled central banks to adopt even more extreme stimulative measures. The ECB, BoJ and now the BoE have all increased quantitative easing in recent months and are moving out the risk curve to corporate debt. (And in the Bank of Japan's case, even into stocks.)

Would we actually have had less spread compression and perhaps less of a risk-on move had the Brexit vote failed? Who knows? But I can't imagine a scenario where we would have had more.

Now, high-yield bonds' rally from their February bottom seemed to stem from the reversal of a virtually bidless environment reversing (with junk bonds briefly reaching 9.5%). But the move since the Brexit vote has felt like a huge technical move spurred on by:

- Inflows. July's first two weeks saw $6.1 billion flow into high-yield mutual funds.

- 'Reach for Yield.' The collapse of global risk-free yields has popularized a mantra that credit investors will have to "reach for yield."

- Commodity Debt. The bid for energy- and commodity-related debt has become seemingly price-insensitive due to new funds being raised and a general underweight to these sectors. This has happened even though oil prices have tumbled since early June (although they've since bounced sharply).

via thestreet