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A new year brought a clean slate and increased risk-taking appetite. January 2023 was the strongest start to the year for credit since 2019 and the second-strongest year since 2009. Credit spreads compressed significantly, with the Option Adjusted Spread (OAS) on the ICE BofA US High Yield Index declining from 481bp to 430bp, finishing the month below the 10-year average, at one point breeching August’s low. The ICE BofA US High Yield Index returned 3.9%. It has proven challenging for the market to break through that trading range. While the high yield market peaked in the middle of the January both from a spread and absolute return perspective, equities kept on grinding higher, undeterred by a steeply inverted yield curve and disappointing guidance from bellwether companies.
Mean reversion trades are alive and well in early 2023. With a disorderly close to 2022, combined with a fresh start that a new year brings, we were not surprised to see a strong bid for risk assets to start the year.
Price movements can shift sentiment, creating either virtuous or vicious feedback loops. While the market may continue to feed on its own momentum for some time, it looks to us like there is a lot of optimism baked into securities prices, with cyclical stocks like Hyatt Hotels Corporation Class A (NYSE: H) and Caterpillar Inc. (NYSE: CAT) both hitting all-time highs in January.
We believe that the current market cycle has a lot of parallels with the unwinding of the tech bubble that played out from 2000 to 2002. Over that period, there were some incredibly sharp market rallies, especially in the most overvalued segments of the market. After a long period of speculative excess, it takes time for valuations to revert to levels that are supported by fundamentals and appropriate risk premiums.
So far in 2023, we have seen massive rallies in the equities of companies that are either on the verge of bankruptcy or currently insolvent, like Bed Bath & Beyond Inc. (NDQ: BBBY) and Carvana Co. Class A (NYSE: CVNA). These price moves should be seen as a warning sign that the risk-taking impulse has become excessive. Despite this, we have seen indications that some market participants who were positioned defensively have decided to pivot and take on a more pro-risk posture. This is evident in very strong performance from baskets of heavily shorted securities, consistent with a short-covering rally.
Even in our own short book, the cost to borrow high yield ETFs has declined to the lowest level since 2021, which is a stark contrast with late September 2022, when the availability of incremental borrow on these securities dropped to zero. There can be times when fundamental developments combined with attractive valuations warrant a shift to a more pro-risk posture.
There are some positive fundamental developments when it comes to inflation in North America: Energy prices have declined and stabilized, and goods inflation has come down significantly. The primary issue for policymakers is that the labor market is still very tight, and services inflation has been relatively steady at elevated levels for the past several months.
The Employment Cost Index (ECI) is one of the Federal Reserve’s favourite inflation measures as it is generally viewed to be more complete and higher quality data than the monthly wage data that accompanies non-farm payroll releases. The ECI for the fourth quarter of 2022 was released on January 31, and while the quarter-over-quarter figure was slightly less than consensus at 1%, year-over-year compensation increases for civilian workers are still running above 5%, which is still very close to the high this cycle, and prior to last year, there was a level of wage inflation unseen in decades.
In North America, capital markets and the economy have handled rate hikes remarkably well to date. This could be because while front-end interest rates are elevated, there is a very steep curve inversion, so that the real yield on the 10-year Treasury or Canada Government Bond is still negative relative to CPI.
There is a possibility that inflation could prove to be sticky around 4%, which, in our view, is not priced into the market, and would be negative for both government bonds and risk assets generally. Forecasting inflation is incredibly difficult, but the market appears to have a high degree of confidence that it will return to 2% in an orderly manner.
When a market is priced for perfection, it’s a very difficult standard to live up to. In our view, spreads are priced for a very benign environment over the near term, with risks skewed to the downside.
Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Manager’s Commentary, January 2022. Used with permission.
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