May 10 2024

The Bond Tilt is Here

Will they, won’t they? The Fed will cut interest rates. One or two times this year the market believes.

Until they do, companies have been squeezing in positive earnings surprises. This has nicely supported the performance of US stocks for now, with S&P500 knocking on the +10%-performance door once again for this year.

Us earnings revisions in positive territory – Citi, Schwab

Strong earnings surprised CEOs themselves in 1Q24, which is leading them to sound more optimistic than they have been over the past 2 years. CEO Confidence Index from ⁦the Conference Board moved up in 2Q2024 to 54. This is the second consecutive quarter in which index was above 50, “indicating that CEOs are cautiously optimistic following 2 years of gloom” according to Sonders at Schwab.

Yet caution prevails, as consumer sentiment is sagging again. The University of Michigan consumer sentiment index dropped again in Ap24.

Jobs are rolling over, and consumer credit is not only harder to come by but also more expensive benchmarked against a prime rate at 8.5%. Although banks appeared more willing to lend in Ap24, the reality is that consumer credit is close to a 3-year low.

One can always argue that the economic plane can fly longer even as fuel sources run low, the sure thing is that its wheels are going to hit the tarmac. Soft landing or not is a detail at this point.

Investors should prepare to rebalance into income-earning strategies that would benefit from a stabilization of a decline in interest rates.

Overall, that’s where capital already has positioned. Since the beginning of the year, fixed income benefited the most. As per ETF flows from 1Jan24 to 3May24, Fixed income ETFs enjoyed about twice as much flows than their relative size, $73bn inflows or 30% of total inflows.

ETF flows YTD24 as of 3May24

The US 10-year US treasury rate is looking attractive at 4.5% for long-term capital holders. Appetite for longer maturity is even coming back. While the Feb auctions for 30-year debt were barely subscribed in Oct23, this week’s 30y auction cleared below the initial yield, at about 4.65%.

If you’re not convinced, think about the $6tn treasure pile sitting in cash-like money markets. It is hard to imagine that these investors would suddenly invest from risk-zero to 20+x PE ratio equities. No indeed, it is highly likely that they would extend their bond maturities, thus sending yields further down, and prices up.

Nobody has to be all-in in fixed income. Rate-sensitive equities are also benefiting from this dovish tilt. Utilities enjoyed a 10% rally over the past month, and are now up 14% for the year, and 94% of S&P500 utilities stocks trade above their 200-day moving average.

Financials and Industrials have also overperformed the S&P500 index over the past month. This is not true for real estate though, which is still plagued by troublesome illiquid inventories.

Equity-premium strategies could well have some more tailwind as well. Such investments are usually long an index e.g. S&P500, and sell calls to secure additional income. While they are set to under-perform the index in bull markets, they over-perform in air pockets. A case in point is JP Morgan equity premium (JEPI) that enjoyed ~$2bn inflows year-to-date.

Don’t get me wrong, bonds have been under-performing equities hands down so far this year. US 7-10y treasuries returned negative 2.7%, US corporate bonds -1.4%, and US high yield a meagre +1.5%. But mind you that annual yields, are now respectively at 4.6%, 5.5%, and 7.9%.

As always, the higher the income, the higher the risk. Credit spreads have compressed since Oct23, and now appear historically thin. Short of digging too far deep into the garbage cans of weaker companies, there is still some decent yield to benefit long-term investment portfolios.

In all likelihood, bonds are now back, not only in larger inflows to the asset class, but also in playing a larger role in alpha generation for portfolios.

That’s all for now !

About –

360 Advisory LLC is a Boston-based RIA managing investments