High Yield Corporates Or The S&P 500?

Stocks are cheap versus high-yield corporate bonds, but our U.S. Investment Strategy service makes a case for favoring the latter.

High Yield Corporate Or Stocks

T otal returns in the high-yield bond sector have kept up with the S&P 500 over the past three years, with far less volatility. One of the reasons why high yield has performed so well versus equities is the inverse relationship between spreads and the level of Treasury yields.

When spreads widened, the Treasury curve shifted lower, mitigating the effect on the level of junk yields. Conversely, when the economy appeared to be on better footing, Treasury yields rose but spreads narrowed. This positive dynamic admittedly will not be as pronounced going forward now that junk yields have dropped to such a low level. Nonetheless, high yield is still attractive, especially in a low-but-positive growth world.

Also, junk bond returns typically match or outperform equities during periods when corporate health is improving – although, more recently there are some worrying developments on this front.  In terms of valuation, junk bonds are expensive relative to equities, but this has been the case for two years. The wide yield gap represents an elevated equity risk premium that we do not believe will quickly disappear.

Bottom line: The latest bout of reflation from the Fed should lift all risk assets, but lower volatility in the bond market is an important reason to favor high-yield bonds for now with the exception of the lowest credit tiers (CCC and below).

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FOMC Meeting: Risk-On!

The message from yesterday’s FOMC meeting is that the Fed has adopted an unambiguously aggressive dovish stance that should carry risk asset prices higher.

The Fed clearly exceeded financial market expetations.

T oday, the Fed announced that it will engage in open ended purchases of mortgage securities as well as extend the forward guidance to mid-2015.

In addition, the statement included:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

In other words, the Fed will increase its rate of purchases if the employment market does not improve substantially. Also, the Fed did this at a time when long-term inflation expectations have been rising. This is quite different from QE2, and shows that Chairman Bernanke is willing to take risks with inflation expectations, which up to this point have been fairly well anchored. The Fed clearly exceeded financial markets’ expectations yesterday. Bernanke has sent a strong signal that ‘whatever it takes’ is not reserved for the ECB.

Bottom line: Yesterday’s actions will extend the life of the liquidity-driven rally in pro-cyclical investments.

BoC And RBA Convergence?

Interest rate differentials may be less supportive, but short positions in AUD/CAD are still warranted.

short positions in AUD/CAD still warranted

B oth the Bank of Canada (BoC) and The Reserve Bank of Australia (RBA) remained on hold at their respective policy meetings this week. In addition, forward guidance of the relative banks is more in step than in recent months.

The BoC made it clear that the next move in interest rates is up, with only the timing of future action still somewhat uncertain:

To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term.

Meanwhile, the RBA projected a more neutral stance than in its past meetings:

With inflation expected to be consistent with the target and growth close to trend…the stance of monetary policy remained appropriate.

Nonetheless, there is still scope for further AUD/CAD downside. Our purchasing power parity model shows that AUD/CAD is overvalued by close to 10%, which is near historic highs. In addition, Australia is more sensitive to base metals, whereas Canada is more dependent on energy, so the breakdown in the relative performance of global materials to energy stocks should be bearish for AUD/CAD.

Bottom line: Although interest rate differentials are less supportive, short positions in AUD relative to CAD are still warranted. The biggest risk to this position is if China introduces aggressive reflationary policies, which would disproportionately benefit the Australian dollar.

Message From U.S. Small Cap Stocks

The underperformance of U.S. small cap stocks has further to run.

Message from U.S. Small Cap Stocks

W e have previously highlighted that technically, U.S. stocks are beginning to look stretched after their summer rally. Another indicator that serves as a warning for the broader market may be the recent underperformance of small caps. Since 2008, small caps have traded as a ’risk on’ asset class, and previous sell-offs have coincided with an underperformance of small caps.

Our U.S. Equity Strategy service notes that their Cyclical Capitalization Indicator is edging lower once again, undermined by a flatter yield curve and persistent weakness in the NFIB survey of the small business sector. In addition, valuation for small caps remains excessive.

The liquidity-driven rally experienced since the Fed’s QE programs began pushed this risky asset class to an overvalued extreme.  The unwinding of this premium is not over, barring imminent and aggressive further easing, and – given Fed Chairman Bernanke’s recent speech at Jackson Hole – the latter is not likely.

All of this suggests that the U.S. small cap underperformance phase likely has further to run, and that the recent broad market rally may be due for a pause, especially if global policymakers fail to follow through with further action.

Stay tuned.

U.S. Consumers Remain Unconvinced

The decline in the Conference Board’s consumer confidence survey, released yesterday, is an outlier relative to other recent data that has beat expectations. Nonetheless, it serves as a reminder of how fragile the recovery is.

US Consumers Remain Unconvinced

C onsumer confidence declined in August according to the Conference Board. This result underscores that in the current environment, it does not take much to shake consumers’ resolve.

Over the past two years, consumer confidence has swung wildly.

In 2010, the European debt crisis first burst onto the scene and, together with soaring food prices, was the likely culprit behind the pullback in consumer spending that year. In 2011, consumers were subjected to another wave of European stress and the debt ceiling crisis in Washington. The surge in gasoline prices late last year no doubt contributed to this year’s soft patch in household spending and confidence. Weather patterns further confuse the picture – “payback” for a warm winter has depressed economic activity in recent months. A small inventory cycle was also at play.

Our base case is that real GDP growth is likely to be stuck in the 2% range, but even this modest growth forecast will require at least some acceleration in the pace of consumer spending growth. Our main concern is the dismal core capital goods orders figures in recent months, which highlights that the fiscal cliff is taking its toll on business sentiment. Potential gridlock in Washington after the election would mean a prolonged period of corporate cautiousness.