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I’m declaring an end to the Covid-19 environment. Bold comment, right? Admittedly, it feels like a lifetime ago that we were living in quarantine, but the ramifications of the pandemic have persisted. Such is life when policymakers flood the global economy with money at precisely the moment that businesses are cutting workers and slashing inventories. That’s not a criticism of policymakers. I believe that true global calamity was averted. Nonetheless, inflation, policy tightening, and fears of recession followed. Some pundits even posited that a new era of inflation – or even worse, stagflation – was upon us. It was only earlier this month when a prominent bank executive warned that interest rates were going to 7%. Or higher! As the gamblers might say, I’ll take the under.
My view was reaffirmed with the 2.75% annual change in the core Personal Consumption Expenditures Price Index in May.1 That’s price stability in my book and within what I’ve always perceived to be the Federal Reserve’s “comfort zone.” It also suggests that the current 5.25%‒5.50% federal funds target2 is likely too tight for the inflation environment. An easing cycle appears to be forthcoming, and with it I anticipate the normalization of the U.S. Treasury yield curve, following 19 months of inversion.3 Normalization is the operative word, even if it has been eons since I last shoved a cotton swab into my brain.
…the U.S. stock market, on average, has historically performed well in the early stages of a Fed easing cycle.4 That is, if the economy is already in a recession before the easing cycle commences or if no recession occurs. Easing cycles that predate recessions have been less conducive to investors. I suppose that’s still a possibility, however our preferred recession indicators, including corporate bond spreads5 and bank lending standards,6 aren’t flashing recession warning signals.
“I think we’re going to see the S&P go down 86% from the top, and the Nasdaq 92%.”
– Economist Harry Dent7
A friend once told me to make outlandish comments to make headlines. It’s never been my goal to make headlines. Personally, I want investors to remain above the noise so that their emotions don’t have them deviating from their investment plans.
Harry Dent certainly made news with his comment earlier in Juine. I’ve even been asked if I give credence to his views. My response is that I put as much credibility in this comment as I did when Dent predicted a prolonged Great Depression starting in 2009 and a plummeting of the Dow Jones Industrial Average beginning in 2012.
Also, remember Dent’s spending wave theory? It was the idea that baby boomers would sharply reduce their spending between the ages of 48 and 63, resulting in extreme financial market duress. Take it from someone who’s 48 and raising two teenage daughters that the spending wave theory is, as President Biden might say, “malarkey.”
I’ve received a lot of questions about the future independence of the U.S. Federal Reserve. Allies of former President Trump have circulated a 10-page document outlining a vision for the central bank that included the president being consulted on monetary policy decisions. A perceived lack of monetary policy independence could have significant consequences for U.S. rates and the U.S dollar.
I asked Jen Flitton, Head of U.S. Government Affairs at Invesco to opine. Her response:
“The system is structured to make it very difficult to disrupt the Fed’s independence. Any formal changes to the operations and/or independence of the U.S. Federal Reserve would require Congressional approval to amend the Federal Reserve Act. Such a change to the statute would need 60 votes in the Senate, an exceedingly high hurdle. Even if the Republicans win the trifecta in November, meaning the presidential election as well as victories in the House and Senate, they will not have the party line votes in the Senate to make any significant changes to how the Fed operates.
That said, you only need 51 votes in the Senate to confirm a new Fed chair. It is possible that in 2026, when Jerome Powell’s term ends, if Trump is president, then a new Fed chair could be more beholden to the White House. Nonetheless, five of the 12 officials on the Federal Open Market Committee will not have been appointed by the winner of the 2024 election.”
Each month I pose a question to ChatGPT – the artificial intelligence-driven chatbot – and assess the response. In June I asked, “Do high-yield bonds perform poorly when corporate bond spreads are tight?”
According to ChatGPT, yes, high-yield bonds tend to perform poorly when spreads are tight. This is because tight spreads indicate that investors are demanding less compensation for the additional risk of holding lower-rated bonds. When spreads are narrow, there’s less room for compensation, and the risk of default becomes more significant relative to the potential return. As a result, the total return on high yield bonds may be lower during periods of tight spreads compared to periods when spreads are wider, and the risk-return tradeoff is more favorable.
It’s a reasonable answer, ChatGPT. However, I’d prefer investors to regard the yield as a reasonable assessment of the five-year forward return, irrespective of the spread environment. The chart below demonstrates that in many different situations, much of the return comes from the yield. Currently, the yield of the Bloomberg U.S. Corporate High Yield Bond Index is 8%.8 That’s potentially a global equity-like return, without the historical volatility of equities.9 I’m not sure I’d want to eschew an 8% yield simply because spreads are tight.
Brian Levitt is Global Market Strategist at Invesco and cohost of Invesco’s “Market Conversations” podcast.
Notes
1. Source: US Bureau of Economic Analysis, 5/31/24.
2. Source: US Federal Reserve, June 2024.
3. Source: Bloomberg, 6/17/24. Based on the difference between the 10-year US Treasury rate and the 3-month US Treasury rate.
4. Based on the average S&P 500 Index performance 12 months before and 12 months after the beginning of the past 16 easing cycles. Sources: Federal Reserve Economic Database (FRED) and Bloomberg L.P., 5/31/24.
5. Source: Bloomberg, 6/17/24. Based on the option-adjusted spread of the Bloomberg US Corporate Bond Index.
6. Source: US Federal Reserve, 5/31/24. Based on the net percent of bank senior loan officers reporting the tightening or easing of lending standards to medium and large businesses.
7. Source: Fox Business, “Economist Harry Dent predicts stock market crash worse than 2008 crisis: The ‘bubble of all bubbles,’” 6/10/24.
8. Source: Bloomberg, 5/31/24. Based on the yield to worst of the Bloomberg US Corporate High Yield Bond Index.
9. Source: Invesco, Bloomberg. Historical volatility measured by the standard deviation of rolling monthly 1-year returns for the S&P 500 Index (0.16) and the Bloomberg US Corporate High Yield Bond Index (0.12) from 7/29/1983 to 5/31/2024.
Disclaimer
© 2024 by Invesco Canada. Reprinted with permission.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
The opinions referenced above are those of the author as of June 20, 2024. These comments should not be construed as recommendations, but as an illustration of broader themes. This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
Forward-looking statements are not guarantees of future results. They involve risks, uncertainties, and assumptions; there can be no assurance that actual results will not differ materially from expectations. Diversification does not guarantee a profit or eliminate the risk of loss. All investing involves risk, including the risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
All figures are in U.S. dollars.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Canada Ltd.
Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that any fund or security will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
Image: iStock.com/crbellette
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