Rates Are In The Driver’s Seat


The third quarter was relatively benign for financial assets as volatility remained subdued, equity markets grinded towards new all-time highs and interest rates steadily tracked higher. Strength in the dollar revealed cracks in emerging market equities and bonds, but for the most part, the Summer doldrums lived up to their name despite media concerns surrounding tariffs, peak-profits, mid-term elections, and whatever other headline became the flavor of the day. We have been adamant that investors ignore the geo-political risks that litter the front page and focus on interest rates, as they pose the largest risk to financial assets - both “risky” and “safe.” Not only are they the discount factor from which all financial assets are priced, but they are the one valuation metric (earnings yield differentials) that has kept adept investors exposed to equity markets throughout this bull market. CAPE ratios, among others, cannot make this claim. And barring a collapse in company earnings, earnings differentials are still attractive, historically. 

Still, it is no coincidence that as Treasury yields jumped to new highs in October, the stock market lost some of its steam. Like the correction earlier in the year, a rate spike provided a catalyst for risk assets to sell-off. And I expect, like earlier this year, it will take some time for markets to consolidate and eventually move higher until the next rate spike. In this manner, there will continue to be periods of elevated volatility and fear, followed by steady advances and complacency. But the consistent theme will be higher rates.

We continue to monitor the macro-data as it is released and are concentrating on three indicators closely: initial jobless claims, high yield spreads, and the spread between the two-year Treasury yield and the 3-month T-Bill yield. The three signals that we believe will indicate an end to the bull market are the following: 

1) High yield spreads breach 400 bps

2) The 4-week moving average of initial jobless claims jumps at least 50k

3) The 2Y-3M spread becomes inverted

As you can see below, as of the writing of this newsletter, none of these indicators are flashing red. As such, it is still a buy-the-dip market, and we will treat it as such. (charts) I suspect that by the time these indicators turn, S&P 500 earnings yield differentials will not be as attractive as they are currently. 

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Disclosure: This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. ...

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