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CORP CREDIT SPREADS FLASH WARNING SIGNALS FOR RISK ASSETS (1212 EST/1712 GMT)
The rising cost for companies to issue debt is a warning signal for risk assets and may indicate lower stock returns going forward.
Companies have benefited from cheap debt to finance their operations, or fund share repurchases and acquisitions, as easy monetary policy holds down interest rates and investors seek out higher risk assets to generate returns. But those costs are now rising as Treasury yields increase and as lenders demand a higher premium over Treasuries for taking on credit exposure.
“The credit spread metric is our canary in a coal mine,” Jack Ablin, chief investment officer at Cresset Wealth Advisors, said in a report sent on Tuesday, and “the canary died last week.”
Ablin looks at the spreads of 10-year BBB-rated corporate bonds, which is the lowest investment grade tier. That spread has now moved more than 10% above its 200-day moving average, which means that “the signal is now risk-off, something we haven’t seen since the height of the pandemic in 2020.”
Historically, the S&P 500 has returned 3.5% over the subsequent six months, on average, after a credit breakdown, compared with a 6.4% return after a positive credit breakout, Ablin said, adding that “the tech wreck of 2001 and the financial crisis of 2008 were preceded by credit breakdowns.”
Meanwhile, rising yields on high yield bonds may start to eat into corporate operating margins, which are at all time highs, according to Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management.
“Historically, higher interest rates are inversely correlated to profit margins as rising cost of capital eats into earnings. This time, rising labor, energy, distribution and commodity costs may be the first to dent margins, but borrowing costs bear watching,” Shalett said in a note sent on Tuesday.
Yields on high yield bonds have increased to 5.58%, from 4.35% at year-end 2021 and a low of 3.92% last July, based on the ICE BofA U.S. High Yield Index (.MERH0A0).
NO NEED FOR DEFENSIVE DRIVING AROUND THIS YIELD CURVE (1101 EST/1601 GMT)
Market chatter has picked up recently over the potential for yield-curve inversion. read more
While a flat or inverted yield curve has predicted the end of a growth cycle at times in the past, Saira Malik, chief investment officer at Nuveen, thinks the current U.S. expansion is "alive and kicking."
From this perspective, Malik says the flatter curve looks more indicative of today's economic "heatwave," and a tip of the hat to the near certainty of associated Fed rate hikes, rather than a "cold snap" down the road.
Malik notes that real interest rates have risen, and the real yield curve remains steep, which she says is another indication that bond markets are not worried about a recession. In other words, inflation expectations are pushing up nominal short-term rates, but investors have faith that the "Fed will keep inflation contained in the long run."
In terms of what it means for portfolio positioning, Nuveen believes that with a low probability of recession, now is not the time to get defensive.
Additionally, Nuveen doesn't think investors should view an inversion of the curve as a timing signal. Malik says that "the yield curve tends to flatten during hiking cycles and typically inverts during or afterward. But historically, even after an inversion, most asset classes have produced healthy returns."
Therefore, Nuveen thinks "it makes sense to maintain risk-on positioning." With this, Malik says they continue to favor a shorter duration stance (e.g., broadly syndicated and private loans), non-U.S. and U.S. small cap stocks and select private assets (e.g., private equity and real assets).
Malik adds that those who do prefer to heed an inversion can consider "de-risking by reducing their overall equities exposure and/or favoring low-volatility, income-generating stocks, and by extending duration into core bonds."
U.S. STOCKS OPEN HIGHER, UKRAINE IN FOCUS (0957 EST/1457 GMT)
U.S. stock indexes opened higher on Wednesday as Western nations placed modest initial sanctions on Russia, with investors focused on whether the Russia-Ukraine crisis can be resolved diplomatically.
The United States and its allies unveiled more sanctions against Russia on Wednesday over its recognition of two separatist areas in eastern Ukraine, while making clear they were keeping tougher measures in reserve in case of a full-scale invasion by Moscow. read more
Stocks gained, however, after the S&P 500 on Tuesday entered into correction territory by closing more than 10% below its record high close reached on Jan. 3.
Small cap stocks led the rally, with the Russell 2000 index (.RUT) rising around 0.78%.
Nearly all of the 11 major S&P 500 sector indexes are green, with gains led by energy (.SPNY), real estate (.SPLRCR) and financials (.SPSY). Utilities (.SPLRCU) are only red sector, falling modestly on the day.
Here is your early trade snapshot:
S&P 500: AS TRADERS TANGO, IT'S CORRECTION VS MOMENTUM (0900 EST/1400 GMT)
The S&P 500 index (.SPX) ended Tuesday down 10.3% from its Jan.-3 record close. With this, the benchmark index confirmed a correction.
The SPX closed at its lowest level since Oct.-4 of last year. Though, it has yet to violate its late-January intraday trough at 4,222.62:
Meanwhile, daily momentum readings may be offering glimmers of hope. This as a bullish convergence pattern may be forming on the RSI.
Just looking at the RSI's behavior around the major lows of the past four years, in October 2018 and February 2020, the oscillator established a deeply oversold trough in the early stages of the declines. In the wake of what proved to be counter-reactions, the RSI failed to muster enough strength to reclaim the overbought threshold. The SPX then went to lower lows.
Ultimately, in these cases, the SPX bottomed with the RSI able to form a higher trough as less severe downside momentum attended the deeper SPX levels.
Recently, on January 27, the RSI plunged to 16.082. The SPX then popped more than 6% in just four trading days. With this, however, the RSI failed to reclaim overbought, and the SPX has now gone to a new closing low.
However, with the RSI ending Tuesday at 32, a positive convergence has the potential to solidify with the 16.082 late-January low now the key level on the indicator.
Thus, traders will be watching the dance between the SPX and the RSI closely. read more
Additionally, of note, the SPX has Fibonacci retracement support of its entire March 2020/January 2022 advance at 4,198.7 and 3,815.2.
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