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May 23 2022

The World Of Emerging Market Bonds

  • May 23, 2022

Investors looking to diversify away from the U.S. interest rate environment and/or the domestic business cycle may wish to consider Emerging Market bonds, an asset class with lower correlations to the U.S. Agg. Bond Index. EM bond investors can choose between several investment attributes to find the risk / return profile with which they are most comfortable. This study surveys the investment tradeoffs offered by each sub-category, as defined by ETFs focused on each particular asset class.

The surge in bond yields this year has certainly wreaked havoc across the economy. The abrupt and sizable rise in the yield structure has proven to be a shock for consumers, homebuyers, and businesses on Main Street; it has also been destructive for stock and bond investors on Wall Street. Although higher yields should help moderate inflation, they have slowed real economic growth and raised recession fears.

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In the MTI update published this morning, we should have mentioned a bullish development in one of our weekly Sentiment indicators. Specifically, Net Insider Big Block Sales have dropped below 1% of issues traded, which boosted the measure to maximum bullish as of last Friday, May 20th.

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Read this week's Major Trend. 

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Well, the drama is over. The S&P 500 reached the bear market threshold (at least intraday), slipping below the -20% Mendoza line. The concern now is how much lower it will go—and where and when a bottom may finally emerge.

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These are just some random remarks about a few unrelated concepts of interest.

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As illustrated by the accompanying chart, every post-WWII bull market has experienced at least one separate correction (defined as a market decline of at least 10% but less than 20%) before ending in a bear market (a drop of 20% or more). But today, the S&P 500 is knocking on the door of a bear-market collapse without having yet experienced an isolated correction.

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Read this week's Major Trend.

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By the end of last year, the annual Consumer Price Inflation (CPI) rate soared to 7% and rose above 8.5% by March. So how did bond yields react to the biggest inflation surge in over 40 years? Since April 2021, the inflation rate has been greater than 4% and ended the year at 7%, yet the 10-year U.S. Treasury yield was only 1.5% as of December and is currently just 2.9%—the lower end of U.S. history. Indeed, looking back to 1872, today’s inflation rate is higher than 88% of the time, whereas the 10-year Treasury yield is still lower than about 80% of the time!

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Losses in the Russell 2000 Growth Index and the NYFANG+ Index have topped 40%, and the only true equity rockstar, spawned by a 13-year secular bull market, has watched her fund’s value drop by more than three-quarters. Yet there’s still a televised debate as to whether this decline is even a bear! Could there be a more devious creature on the face of the planet?

 

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The CPI numbers were hotter than expected. Our Scorecard still suggests cost-push inflation continues to have an upper hand in driving inflation higher, an unfavorable scenario for risky assets.

 

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Could the recent surge in bond yields finally be reaching a standstill? Who knows for sure, but there are some encouraging signs signaling at least a temporary intermission?

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Read this week's Major Trend Index.

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Consumers have enjoyed some positives in the last year, including a strong jobs market and rising wages. Overall, however, they have faced an increasing array of challenges that have dampened spirits. Fiscal stimulus has run dry, budgets have been pressured by a price upswing in nearly everything, interest rates are much higher, and despite elevated wages, the real wage rate has been declining. In addition, the headlines have turned increasingly dark: a protracted war in Ukraine, yet another COVID-variant upwelling, a potential policy mistake by the Federal Reserve, a stock market collapse, and widespread talk of an imminent recession.

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The group is back to where it was before the pandemonium began, both on a price and valuation basis. While the move is likely to overshoot below median and historical lows, we think we’re closer to the final chapter than the midpoint.

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Bulls have been quick to assure us that this market “bears” no resemblance to the dot-com bust. We agree—but probably for very different reasons. Among them are the conventional breadth measures, which provided little warning of this year’s January peak. And, the initial decline off January’s top has been much broader than during the first phase of the dot-com bust.

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Those once high-flying FAANG stocks continue to run into rough pockets of air. Following Facebook’s 33% dive in February, Netflix (-49%), Amazon (-24%), and Google (-18%) followed suit in April as the latter two trillion-dollar firms posted their worst monthly returns since 2008. Only Apple—which still carries an enormous 7% weight in the S&P 500—has avoided a recent gut-wrenching plunge.

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Market conditions leading up to the May rate hike were similar (if not worse) than those that triggered Powell’s late-2018 “pivot.” Free-market tightening of 2022 is apt to play into the path of policy. There’s likely a dovish “pivot” in store later this year—one that may be aggressively sold rather than bought.

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Most U.S. dollar drivers point to a stronger dollar: attractiveness of U.S. assets; policy differentials; real interest-rate differentials; terms of trade; weaker Yuan; and capital flows/hedging activity. Speculative positioning, however, is a negative and suggests the dollar rally might at least take a pause in the near term.

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The April haircut in the S&P 500 (-8.8%) combined with February and January losses brought a few of our 1995-to-date “Estimating The Downside” measures very close to their 27-year medians for the first time in recent memory. At present, downside to the median is now -16%. Based on 1957-to-date, the S&P 500’s estimated downside to the median is -30%.

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Lately, “TECH” has truly become a “Four Letter Word.” After a prolonged leadership run that began long before the pandemic, and became dominant in early 2020, technology stocks have entered a bear market. The S&P 500 Technology index and Nasdaq 100 (the QQQ) are now off from record highs by over -20% and -22%, respectively. This has left many wondering whether the financial markets are again headed for a replay of the 2000 dot-com collapse. 

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As the following chart pictorial illustrates, several key ingredients that underlie pricing pressures are losing their inflationary force. These include the systemic impact of rising inflation expectations, the coincident contribution of higher commodity prices, and the leading influence of economic policies. There is also notable progress among several supply-chain problems, including a surge in the U.S. labor supply, improvement in international freight rates, a rollover in backlog orders, and evidence that companies are finally rebuilding inventories.

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With so much worry swirling around contemporary Federal Reserve actions and imminent recession risk, history provides a good reminder that Fed-tightening cycles have almost always taken considerable time before bringing about a recession.

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Lent ended last week, allowing Christians to resume the intake of unhealthy foods. But rather than a nice, thick T-Bone steak, we’d suggest sampling one of the few items that’s fattened investors’ accounts in 2022—the Donut!

 

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For stock investors, the most important issue surrounding the inflation environment is not how high it is nor how long it may stay above the Fed’s target rate. Rather, it is whether inflation is nearing a recovery peak: Even if it remains elevated for some time, if inflation is nearing a top, the stock market has historically produced satisfying results. That is, stocks have done well in periods following a peak in the inflation rate. Consequently, today, with inflation this extreme (and probably close to topping out), it’s time to buy!

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Read this week's Major Trend.

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We worry so much about the Federal Reserve. How far are they behind the curve? When will they start taking away the punch bowl? Is the fed funds rate alarmingly below the Taylor Rule? How fast will the Fed push interest rates higher? Will they opt for a 50 basis-pointer? Maybe multiple 50s? Could there be an intra-meeting hike? What is the terminal yield target? QT could be a killer! Do those dot-plots suggest a curve inversion? Oh my, even the Doves are Hawkish!

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VIX® is the popular name for the Chicago Board Options Exchange CBOE Volatility Index®. It measures the stock market’s expectation of future volatility based on S&P 500 index options. When investors expect more instability, they perceive greater risk, and for that reason, the VIX is often referred to as the market’s “fear gauge.”

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The CPI numbers are largely in line. Our Scorecard still suggests high inflation pressure for now, but there are indications that inflation has probably reached a medium-term peak and the pricing for Fed rate hikes will likely come down.

 

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Read this week's Major Trend.

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Theoretically, there is a supply and a demand, and they are brought together only by price. Obviously, both are important because when they get drastically out of whack, inflation rises or falls—or deflation develops. For this reason, it’s useful to separately monitor their developments in real-time. To fully appreciate the underlying source of inflation, one needs to acknowledge the status of “both” supply and demand. It could be too much demand or too little supply. Often, it’s a bit of both.

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Bond yields across the curve have been exceeding the speed limit lately, zooming toward an unknown higher equilibrium. Since year-end, the 10-year Treasury yield has climbed from 1.5% to 2.6%; it has surged from 1.75% just since the end of February! With the Federal Reserve now joining bond vigilantes with their own “pedal-to-the-metal” toward monetary tightening, who knows how “fast” yields might continue to advance? For investors, this begs the question, “Does SPEED Kill… Stocks?” Although yield levels are still fairly low, if they rise fast enough, can equities withstand such a monetary shock?

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Next month kicks off the seasonally-weak phase of the stock market’s Annual Cycle: May-October. Overlaid on that is the statistically vulnerable stretch of the four-year Election Cycle: the “mid-point” of the Mid-Term Year. There’s a positive way to spin this mid-term malaise: The cycles imply that an ideal window for a major low is about to open.

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In a simple test of 15 yield-curve variants, we found that the 2s10s spread ranks second to last, based on its correlation with one-year-forward real-GDP growth since 1978. The three best measures employed the 3-month bill as the “short” rate. The spread between the 5-year note and 3-month bill showed the strongest correlation with subsequent economic growth.

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Through the first two-and-a-half months of 2022, factor performance maintained the trend established in 2021: Value outperformed everything else and Growth lagged. When the 10-2 year differential dropped near 20 bps on March 16th, Growth stocks outperformed from that day forward, while Profitability and Value suffered.

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Currently, the dashboard shows 6 green, 3 yellow, and 2 red lights. The overall message is that, while there are areas of concern, a recession is unlikely to be imminent (within the next twelve months).

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Predicting a recession is a very tall task, let alone using a single yield-curve indicator with long and highly variable lead time. Instead, we would rather focus on some of the more reliable themes: The macro-policy setting; U.S. dollar; and Bank stocks.

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Investors considering a position in the Consumer Discretionary sector need to be aware of what they are buying: a basket in which one-half consists of mature, modestly-valued consumer brands, while the other half is two mega caps with excellent growth profiles and high absolute valuations. It would be a mistake to view this sector as a homogeneous set of companies.

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Read this week's Major Trend.

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