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Fixed Income – In this article you’ll find:
- Fixed income markets tell us a story about the health and potential future direction of the economy
- Why should we monitor the credit spread on fixed income?
- Let’s make a fast update on Sovereign Bond Yields
- US inflation remains elevated
- How Market Concentration Impacts Performance
Here you can find other articles:
- Inflation 3 scenarios for 2023
- Recession YES or Recession NO?
- Is the FED making the same mistake of 70s?
ENJOY THE ARTICLE
Fixed-income markets often tell a story about the overall health and potential future direction of the economy and capital markets.
In the past, the yield curve has been a powerful predictor of future economic direction, including potential recessions.
Wells Fargo Advisors believes monitoring credit spreads may also paint a picture of market liquidity, and the perceived health of corporate balance sheets.
With a meaningfully inverted curve and high-yield spreads well below the July 2022 peak, the bond market is sending mixed signals.
The yield curve is essentially the difference between shorter- and longer-term interest rates.
The yield curve has been inverted since July 6, 2022, as markets anticipated multiple Fed rate hikes, pushing short-term rates higher.
Bond market conviction that the Fed will lower inflation closer to target levels combined with the prospects for an economic slowdown has kept longer-term rates relatively contained, resulting in yield curve inversion.
While an inverted curve has often been a predictor of an upcoming recession, using this indicator to time a recession can be challenging, as it may take as long as two years from initial inversion to recession.
During periods of market stress, credit spreads have tended to move higher as investors seek out higher-quality fixed-income investments and the future becomes more uncertain.
Last year, high-yield credit spreads hit a high near 583 basis points (100 basis points equals 1%) over the 10-year U.S. Treasury yield, indicating economic concerns and decreased investor confidence in corporate balance sheets.
Recently, high-yield credit spreads have tightened to near 400 basis points over comparable Treasury securities. Current high yield spread levels indicate that the bond market’s near-term economic concerns have eased in recent months.
Sovereign Bond Yields update
FED, Neutral, FED expects 25bps rate hikes in March, May, and June before a pause in policy action into 2024. Expected terminal rate: 5.25-5.50%
ECB, Neutral, ECB expects a 50bps rate hike at the March meeting, followed by two 25bps rate rises in May and June. That said, firm inflation signals, resilient activity and hawkish policymaker commentary presents upside risks to both our terminal rate projection and the pace of tightening. Expected terminal rate: 3.5%.
BOE, Dovish, BOE expects a final 25bps hike in March followed by an extended pause. Expected terminal rate: 4.25%.
BOJ, Hawkish, BOJ – The recent widening of the yield curve control band suggests this policy may be tweaked further or abandoned over the coming year.
Goldman Sachs also thinks there is a high likelihood of a rate rise and departure from NIRP.
US inflation remains elevated
Core PCE inflation, the Fed’s preferred measure of price rises, increased 4.7% year-overyear in January.
This upside surprise relative to expectations implies the path to disinflation may be gradual.
Considering recent robust data, Goldman Sachs anticipate three further 25bps rate hikes for a terminal rate of 5.25-5%, which is an increase from our prior 5-5.25% projection.
February has quelled hopes of a quick and painless return to 2% inflation. The Fed will need to step up the game.
Nordea Asset Management expects 10Y treasury rates will need to set new cycle highs before they see a marked cooling in the labour market.
Markets and the Fed were coming into February hoping that the disinflationary trend seen since early November would carry inflation all the way down to 2% already this year, enabling a swift reversal of monetary policy starting already this summer.
But data since then has put those hopes to rest.
Inflation data for January and revisions to 2022 price data shows that price pressures are still very much with us.
Fed’s preferred measure of underlying inflation, services ex housing is running at twice their 2% target and even goods inflation is showing signs of turning up again after falling for more than a year.
How Market Concentration Impacts Performance
Markets have been off to a strong start in 2023, but a number of risks remain in the path of the market, including the risk of a U.S. economic recession, elevated inflation, a slowdown in corporate earnings, and still rising geopolitical tensions, to name a few.
With the potential for market volatility ahead, Merrill Lynch believes remaining disciplined and diversified is the best way to position portfolios.
But how diversified is your Equity portfolio? Looking at the S&P 500 Index, market concentration of the five largest members of the index account for 18.4% of the S&P 500’s value, up from 11.2% a decade ago.
Looking beyond the index, not all styles and sectors have the same concentration risk.
For example, the Russell 1000 Growth Index has become increasingly concentrated over the past decade; the same is not true for the Russell 1000 Value index.
While the top five stocks in the Growth index make up 33.0%, that number is only 11.4% in the Value index.
On a sector basis, there is a similarly wide range of concentrations across the 11 S&P sectors (Chart above displays concentration and return metrics for the various Global Industry Classification Standard (GICS) sectors).
In the short term, sectors with high concentration tend to experience increased bouts of volatility.
Since its 2018 reshuffle, Communication Services has been very top heavy and currently stands as one of the most concentrated sectors, with the top five members accounting for nearly 69.0% of the sector’s value.
This proved beneficial for Communication Services during periods when heavyweight members performed well, exemplified by the sector’s gain of 20.5% in 2021.1 But, as top members began to tumble, they played a notable role in the sector’s -40.4% return in 2022.
On the other hand, Healthcare is one of the least concentrated sectors, with 33.9% of its weighting coming from its top five companies.
Its diversity of members may help to stabilize returns, allowing it to perform well in different market conditions and cycles.
For example, always chart above shows that the Healthcare sector has maintained low volatility and significant positive returns, relative to the market’s overall performance, in the last one and five years, increasing 1.8% and 68.0%, respectively.
Sector’s concentration level
Overall, a sector’s concentration level could have a noteworthy impact on the performance of both the sector and the greater index.
It is important for investors to consider not just size, style and manager preferences, but constituents and their respective weightings as well.
Having an awareness of the true concentrations within a diversified portfolio can benefit investors by helping to protect against the downward swings that may accompany periods of volatility.
Join the conversation with your own take on these topics in the comments below.
About the Author
Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.
In doing so he shares with you the most interesting charts and comments.