The Daily Prophet: Stock Bulls Should Give Thanks to Junk Bonds

Connecting the dots in global markets.

The S&P 500 Index topped 2,600 for the time on Tuesday before closing just shy of that level, and everything from emerging-markets to commodities and even long-term government debt securities joined in the good times. Those looking for a reason behind the broad-based rally could do a lot worse than crediting junk bonds.

There was a lot of handwringing as the Bloomberg Barclays U.S. Corporate High Yield Index fell 1.3 percent between Nov. 6 and Nov. 15. Although that isn't much in a historical context, it was enough to spark concerns that a long-predicted selloff had finally arrived. But since then, the index has recovered more than half its losses and no one this week seems to be talking about canaries in coal mines or early-warning systems or cracks in the markets. Investors jumped back into exchange-traded funds that hold junk bonds on Monday, pumping $371 million of new money into them, data compiled by Bloomberg show. Dollar funds led gains, with BlackRock Inc.’s $19 billion HYG ETF posting its biggest inflow in almost seven weeks, according to Bloomberg News' Natasha Doff. The amount likely continued to pour in Tuesday, as yield spreads continued to tighten on optimism for stronger corporate earnings and an economy that seems to be expanding no matter where you look.

Moody's Investors Service said this week that its Liquidity-Stress Indicator fell to a record 2.7 percent in October, and is tracking even lower this month. That suggests corporate borrowers are having little trouble meeting debt obligations. “Speculative-grade liquidity continues to improve due to strong credit markets, the recovery in oil and gas, and a growing US economy that is bolstering corporate earnings and cash flow,” Moody’s Senior Vice President John Puchalla said in a research note. “The declining LSI presages a lower (U.S.) speculative-grade default rate, which we forecast will fall to 2.1 percent in October 2018 from 3.2 percent today.”

Rather than pull back in response to weakness in credit markets, Goldman Sachs, UBS and BMO Capital Markets have all raised their forecasts for the S&P 500 in recent days. The equity advance that started in 2009 is likely to last three more years, driven by “rational exuberance” that hinges on profit growth, Goldman Sachs strategist David Kostin said. If that happens, the bull market would exceed the 10-year run during the internet frenzy as the longest in history, Bloomberg News' Lu Wang reports. Kostin increased his 2018 target for the S&P 500 to 2,850 from 2,500. BMO Chief Investment Strategist Brian Belski forecasts the S&P 500 will end 2018 at 2,950, just topping the 2,900 target UBS AG’s Keith Parker issued last week. The bears are trying to draw comparisons between today’s bull market and that of the late 1990s, but the market's breadth suggests the link may be unwarranted, according to Bloomberg News' Sarah Ponczek. More than 70 percent of S&P 500 members are rising, analysts at Strategas Research Partners wrote in a note Tuesday. That wasn’t the case in 1999, when less than half of S&P 500 members advanced. In 2007, before the crisis, just 50 percent of stocks ended the year higher.

Call it the quiet bear market in bonds. While yields on longer-maturity Treasuries have fallen amid signs that inflation is in no jeopardy of accelerating, those on two-year Treasuries have soared, from 1.25 percent on Sept. 8 to 1.78 percent on Tuesday. The increase is a reflection of the Federal Reserve's hawkishness, with the market now pricing in a greater 60 percent chance the central bank raises interest rates twice more by the end of March. Even so, the rise in yields has been remarkable. Using the Relative Strength Index to gauge the resulting drop in two-year note prices brought on by the rise in yields indicates that part of the yield curve is more oversold than any time since 1994. "Yields are of course still very low but the sharp move higher does reflect a market that initially doubted the Fed’s desire to hike as they planned on doing going into 2017," Peter Boockvar, the chief market analyst at The Lindsey Group, wrote in a research note. At a level of 82, the Relative Strength Index for the 2-year note is well above a reading of 70, which signals that an asset has moved too far, too fast and may be due for a reversal. A widely followed JPMorgan Chase client survey for the week ended Nov. 20 found that sentiment toward U.S. Treasuries is holding at levels that are more negative now than any time since early 2006, which was a tough time for bonds.

While every emerging-market is enjoying a rebound from the recent selloff, Turkey is going in the opposite direction amid a standoff between central bank Governor Murat Cetinkaya, who’s being pushed by markets to raise interest rates, and President Recep Tayyip Erdogan, who is urging lower rates. The lira was the world's worst-performing currency Tuesday, falling as much 1.2 percent, bringing its losses for the year to 11.1 percent. Erdogan said last week the bank was on the “wrong path” in using high interest rates to tackle inflation, an argument based on an unconventional view of economics that sees higher rates as a cause of inflation, rather than as a tool to control it, according to Bloomberg News' Tugce Ozsoy and Constantine Courcoulas. In economies like Turkey’s, where the biggest contributor to cost inflation is interest charges, trying to curb price pressures with higher interest rates is “like throwing gasoline on the fire,” Cemil Ertem, one of Erdogan’s chief advisers, wrote in a column in Milliyet newspaper on Tuesday. The yield on the nation’s benchmark 10-year bonds climbed 20 basis points to 13.10 percent, after touching a record 13.16 percent. The central bank will probably need to raise interest rates by 150-200 basis points to make a difference, according to Kiran Kowshik, a strategist at UniCredit in London.


The market for raw materials also posted gains Tuesday, with the Bloomberg Commodities Index rising 0.33 percent, but that doesn't mean investors can look forward to better times ahead. With the exception of 2016, it's been a rough seven years for the sector, and JPMorgan isn't ready to signal the all clear. In its 2018 outlook for the market, the bank's strategists say in order to make money, investors will need to pick assets, such as agriculture, and play short-term trends to take advantage of price swings, rather than buying and holding a broad basket of commodities, according to Bloomberg News' Lynn Thomasson. Among the highlights of the report are predictions that oil markets will stay balanced in 2018 due to extended OPEC-Russia production cuts, keeping Brent crude in the high $50 a barrel range. "Aside from a revival in shale efficiency, the main downside risk is for an early and disorderly end to OPEC-Russia price support, potentially as producers refocus on market share,” the strategist wrote. For metals, they see copper and nickel prices declining as supplies rise. After a poor showing this year, agriculture could do well in 2018, as JPMorgan says go long on Kansas wheat and sugar. Also, the cotton market could tighten on strong consumption and Chinese imports.

Despite the temptation to leave work early Wednesday for the Thanksgiving holiday, investors and economists in the U.S. will likely need to stick around to for the release of the minutes from the Fed's Nov. 1 meeting at 2 p.m. New York time. The central bank refrained from raising interest rates at that meeting, but signaled in a short statement that it was confident inflation, which was running at about 1.3 percent, would rise to its 2 percent target and that a rate increase would be warranted in December. The economists at Bloomberg Intelligence say the minutes should be scrutinized for clues about how policy makers were assessing financial conditions, interpreting growth dynamics and considering a lower level of NAIRU, or the non-accelerating inflation rate of unemployment. Thus, the minutes may reveal something about the course of rates in 2018, depending on the degree to which financial stability concerns are intensifying.

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