October 20 2023

The Odd Stage of Rates-cession

Geopolitics gives us plenty cause for concern. The recent terror attacks on Israel, threatening to escalate into a Middle-East fireball, adds to the existing war in Ukraine. The stress level has been palpably higher.

Markets are on a spin. But not solely for geopolitical unrest, as until this escalates into a multi-front war, this has no immediate impact on commerce or energy supply.

The main reason for volatility is the odd couple of rates and a looming recession, or rates-cession.

Contrary to what we would expect in a risk-off scenario, US treasuries yields are rising. Investors are net sellers of US treasuries, short and long.

There are a few reasons behind that: Fed is a seller as part of its effort to reduce its balance sheet. Institutions are selling to recoup some losses on their Government holdings, as banks alone have $400bn negative mark-to-market on these securities. At the same time, hedge funds are punting on bear steepening and sell the long-end. On the flipside, retail investors take refuge in money market for safety, while some YOLO into taking the long on 20yr+ treasuries, not managing to buck the trend yet.

Bond yields have been rising so much that equity yields look pale in comparison. The spread between S&P500’s forward earnings yield and 10yr Treasury yield stands at the lowest since 2002.

What gives? nothing for now, as we have high rates AND high equity valuations.

Actually equity valuations don’t look so out-of-touch. It is now notorious that only 7 stocks have made the fortune of S&P500 this year. Outside tech, US stock valuations are probably fair. Stock value looks even fairer if we look at the UK, Japan, or Emerging Markets. So, call it a “AI tree hides the forest” if you will, but reality is that the equity world has been actively pricing in some form of slowdown.

How do we allocate then? Volatility is our opportunity. Mark Twain said “opportunity is a strange beast, it frequently appears after a loss”. Entrepreneurs live by this roller coaster mantra, capital market investors too.

At the end of Sep23, JP Morgan projected a forward 7% annual return for US large cap over the next 10-15 years. Any further downside from now is an opportunity to add.

After the sharp rate repricing, quality credit looks attractive at current level. US investment grade corporate bond currently yields 6.37% with a median duration of 5-7 years. Although it is quite possible that the full impact of recession has not fully played out in spread widening, I expect this to be mild on 5-7 yr investment grade credit. However, I am still cautious on high yield in Western countries.

Overall, the current market offers great opportunity for the 60-40 portfolio investor, with cash at 5+%, investment grade at 6+%, and equity from 7% to 10% total return.

Despite the current feeling that the world is going haywire, there is no reason to panic, and we should embrace uncertainty with a diversified portfolio.

Tail-end risks persist though. The recent banking earnings revealed credit concerns. Smaller banks would remain under the cosh, and the BKX index is revisiting its Mar23 lows.

There is also a chance that corporate credit spreads suddenly widen again, even though both investment grade spreads at ~150bps, and high yield spreads at ~450bps already stand around historic average.

And of course, there is the ever-present specter of war, which has sent oil and Bitcoin prices rising over the past 2 weeks.

In short, falling knives are plenty but the long term and diversified investor wears Kevlar gloves.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments