Rudi’s View: Bond Market Says Regime Change Is Upon Us

Rudi's View | Apr 19 2023

In this week's Weekly Insights:

-What's Up, Doc?
-Bond Market Says Regime Change Is Upon Us
-Banks (Dividends) In Focus
-Conviction Calls & Best Ideas
-Research To Download
-FNArena Subscription
-Webinar on Copper

By Rudi Filapek-Vandyck

What's Up, Doc?

There's a near unanimous view among share market observers that from a technical analysis point of view, global equities seem in a solid uptrend in April.

Those that have a view on the fundamental underpinnings also highlight the discrepancy with the technical picture. If anything, the chances for economic recession in the US this year are increasing, yet equities seem to be preparing for a party like it's 1999.

Don't fight the tape versus don't fight the Fed?

Short-term versus further-out?

There's plenty of anecdotal evidence suggesting institutional investors are not fully participating in this month's rally. Probably because, you know, that recession (and still too optimistic forecasts).

Research by Canaccord Genuity shows the S&P500 has never bottomed before economic recession, hence if late last year's trough turns out The Bottom for the current cycle, it would mark the first time with Canaccord's research dating back to the recession from 1957-58.

Back in 2001, the index didn't bottom until the recession was well and truly in the rearview mirror.

Canaccord's strategy is to remain patient, keep plenty of cash on the sideline while skewing the portfolio in favour of defensives, and standing ready to pounce when bad news arrives and equities are being pushed back below the October low.

Meanwhile, strategists at Morgan Stanley have to deal with complaints from customers whose patience is running thin.

The above sums it up quite nicely, I think.

Bond Market Says Regime Change Is Upon Us

One of the more fascinating pieces of market research has come from analysts at Brandywine Global, essentially deciphering the impact bond markets exert on equities based on historical precedents since the 1970s.

In summary: investors should ditch their "cheap" looking laggards and highly speculative exposures and instead opt for 'Profitable Quality' that isn't as yet overpriced. Brandywine's favourite measurement of what defines a Quality company is a high Return on Equity (RoE).

While a change in bond market dynamics has swung the market momentum pendulum away from Growth equities in favour of 'Value', Brandywine's research suggests the fact bond market curves are currently inverted is the all-important input.

Inverted bond market curves occur when shorter-dated debt carries a higher yield than longer-dated debt, traditionally seen as your typical precursor to an economic recession.

History shows, the research suggests, so-called 'Deep Value' stocks do not perform well when bond market curves are inverted, as is currently the case. The situation changes when the curve normalises, but this looks like a long while off as yet.

As explained by Brandywine, for the curve to steepen back into positive territory, the Federal Reserve needs to start cutting interest rates, and significantly so. While this signals more imminent economic trouble is forthcoming, for equities this opens up significant widening of valuation spreads leading to the beginning of a so-called Deep Value Regime, as overall returns shrink.

The underlying logic here seems to be that investors start doubting how much return can still be achieved from equities when the central bank is forced to aggressively lower interest rates, which only happens when trouble is on the horizon.

Thus investors seek safety in beaten-down assets that subsequently offer superior return, either through outsized dividends or a valuation that simply won't fall further.

In summary: when bond yield spreads are narrow and begin to widen, equity markets are in the 'Broad Value' regime. This is when profitable companies with a high RoE outperform their cheaper and lower quality brethren. When spreads are extremely wide and begin to narrow, this marks the start of the 'Deep Value' regime.

Let's try to translate this historical pattern in modern day layman's terms: when the bond market is signalling challenging times lay ahead, investors in equities become more circumspect about where to allocate their money, shying away from taking on too much risk.

Instead they start looking for profitable companies with a higher quality profile that, essentially, represent less risk.

Even without the guidance of Brandywine's bond market whisperers, the above makes all the sense in the world to me.

FNArena has this year expanded the available data on 2200-plus ASX-listed companies, including metrics such as Return on Capital Employed, Return on Equity and Free cash flow after dividends. Alas, our service does not yet include the option of ranking companies on those metrics, but subscribers have access via a company-specific search in Stock Analysis.

See also previous editions:

-https://www.fnarena.com/index.php/2023/04/05/rudis-view-dont-be-hoodwinked/

-https://www.fnarena.com/index.php/2023/03/22/rudis-view-all-weather-stocks-back-in-fashion/