For all the headlines generated by the October stock market sell-off, equity investors should note that the real action, in many respects, has been taking place in the fixed income markets. What happens in bond markets often leads what happens in equity markets, simply because risk-free Treasury markets are the basis for equity analysts’ discount rates and credit markets are the lifeblood of the private sector economy.
First, credit markets came under real pressure for the first time this year; then, last week, Federal Reserve Chairman Jerome Powell dropped a bit of a bombshell concerning the future path of U.S. interest rates.
‘Just Below Neutral’
As recently as October 3, the Fed chairman said that U.S. rates were “a long way from neutral”—that is, the level at which they neither fire up nor dampen inflation. In many ways, this is what sparked the equity market sell-off in October. Last Wednesday, to the surprise of market participants, he described them as “just below neutral.”
The extent of this U-turn was reflected in the subsequent market repricing. The S&P 500 Index finished the day up 2.3%; rates markets appear priced for just one-and-a-half hikes for 2019, against the Fed expectation for three; Treasuries caught a bid, the dollar index shed 0.55% and emerging markets assets got a major boost.
Equity markets often struggle during rate hike cycles, so any pause to, or end of, this period of rising rates could be viewed positively. That said, it might seem counterintuitive that risk assets would respond so positively to this news.
After all, Powell also emphasized that the Fed would be “paying very close attention” to economic and financial data, indicating concern about falling levels of growth and inflation, as well as market stability. If rates have moved closer to neutral without any hikes, that implies lower expectations for economic activity, higher perceived risk of market shocks, or both.
Credit Markets and Trade
The credit markets might be seen to be signaling similar concerns.
November saw negative sentiment sweep through corporate credit markets. High yield index spreads are now some 60 basis points wider than they were at the start of the year, with 75% of that widening occurring in November. They now trade at around 400 basis points over Treasuries. Euro high yield went through a comparable sell-off.
The riskiest, CCC rated part of high yield sold off hardest. Cyclical sectors, such as energy and homebuilders, and those with exposure to global trade policy, such as autos, led the way down. In investment grade, at the end of October, General Electric’s credit rating was downgraded to BBB+, but in November it slumped to pricing more like BBs. That raised questions regarding other large, deteriorating BBB issuers and the capacity of the high yield market to absorb future downgrades from this sector.
Slowing growth and trade tensions have remained in the news, and will have been the topic of conversation between Presidents Trump and Xi at the G20, as this Weekly was going live. The market is pricing in a constructive outcome, but a more comprehensive new approach on trade with China will be a much longer-term project, fraught with ups and downs.
But let’s look at these bond-market phenomena from another perspective.
First, maybe the Fed is seeing dark clouds that are invisible to the rest of us. In fact, the Fed is likely recognizing a slowdown that markets have acknowledged for some time. That implies less risk that the Fed will tighten too quickly next year—which would likely bode well for equity markets.
Similarly, just as I wrote that the “scary” sell-off in equity markets was “more of a late-cycle correction than an indication that the cycle is over” a month ago, today we would say the same about the sell-off in credit.
For sure, last week’s Fed downshift raises credibility questions in fixed income markets. Was this based on data or on what’s come out of a certain Twitter account lately?
That aside, if the credit market remains open for business, interest rates become more stable and trade uncertainty is mitigated, things may begin to look somewhat less scary for equity markets than they did a month ago.
The Powell rally in risk assets may not have been counterintuitive, after all.
Joseph V. Amato is President of Neuberger Berman Group LLC and Chief Investment Officer—Equities at Neuberger Berman. He is also a member of the firm’s Board of Directors and its Audit Committee. To learn more, see Mr. Amato's bio or visit www.nb.com.
In Case You Missed It
- S&P Case-Shiller Home Price Index: September home prices increased 0.3% month-over-month and increased 5.1% year-over-year (NSA); flat month-over-month (SA)
- U.S. Consumer Confidence: -2.2 to 135.7 in November
- U.S. 3Q18 GDP (second estimate): +3.5% annualized rate
- U.S. New Home Sales: -8.9% to SAAR of 544,000 units in October
- U.S. Personal Income and Outlays: Personal spending increased 0.6%, income increased 0.5% and the savings rate decreased to 6.2% in October
- FOMC Minutes: Show the Fed remains on track for a December rate hike
What to Watch For
- Monday, 12/3:
- ISM Manufacturing Index
- U.S. Purchasing Managers’ Index
- Euro Zone Purchasing Managers’ Index
- Wednesday, 12/5:
- ISM Non-Manufacturing Index
- Thursday, 12/6:
- U.S. Durable Goods Orders
- Friday, 12/7:
- U.S. Employment Report
- Euro Zone 3Q18 GDP
Statistics on the Current State of the Market – as of November 30, 2018
|S&P 500 Index||4.9%||2.0%||5.1%|
|Russell 1000 Index||4.8%||2.0%||4.8%|
|Russell 1000 Growth Index||6.1%||1.1%||7.8%|
|Russell 1000 Value Index||3.6%||3.0%||1.5%|
|Russell 2000 Index||3.0%||1.6%||1.0%|
|MSCI World Index||3.4%||1.2%||-0.7%|
|MSCI EAFE Index||1.0%||-0.1%||-9.0%|
|MSCI Emerging Markets Index||2.7%||4.1%||-12.0%|
|STOXX Europe 600||0.8%||-1.1%||-11.0%|
|FTSE 100 Index||0.4%||-1.6%||-5.4%|
|CSI 300 Index||0.9%||0.6%||-19.5%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.1%||0.3%||0.7%|
|Citigroup 10-Year Treasury Index||0.4%||1.4%||-2.9%|
|Bloomberg Barclays Municipal Bond Index||0.5%||1.1%||0.1%|
|Bloomberg Barclays US Aggregate Bond Index||0.1%||0.6%||-1.8%|
|Bloomberg Barclays Global Aggregate Index||0.0%||0.3%||-3.2%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.4%||-1.1%||2.6%|
|ICE BofA Merrill Lynch U.S. High Yield Index||0.4%||-0.9%||-0.1%|
|ICE BofA Merrill Lynch Global High Yield Index||0.2%||-1.0%||-2.3%|
|JP Morgan EMBI Global Diversified Index||0.5%||-0.4%||-5.5%|
|JP Morgan GBI-EM Global Diversified Index||0.2%||2.8%||-7.4%|
|U.S. Dollar per British Pounds||-0.4%||-0.1%||-5.7%|
|U.S. Dollar per Euro||-0.2%||-0.1%||-5.7%|
|U.S. Dollar per Japanese Yen||-0.7%||-0.6%||-0.8%|
|Real & Alternative Assets|
|Alerian MLP Index||1.5%||-0.8%||-3.4%|
|FTSE EPRA/NAREIT North America Index||2.3%||4.6%||4.6%|
|FTSE EPRA/NAREIT Global Index||1.5%||4.3%||-0.7%|
|Bloomberg Commodity Index||1.4%||-0.6%||-4.7%|
|Gold (NYM $/ozt) Continuous Future||0.2%||0.9%||-6.4%|
|Crude Oil (NYM $/bbl) Continuous Future||1.0%||-22.0%||-15.7%|
Source: FactSet, Neuberger Berman.