Weekly Update

April 22, 2016 Update

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Inflation trade ramps up

Over the past month markets have shifted once more in dramatic fashion with commodities surging higher across the board. This has brought sectors like mining and oil drilling back from the dead which, in turn, has led to a sharp recovery in high-yield bonds. Take a look at the stunning reversal of fortune:

EEM iShares MSCI Emerging Markets NYSE + BATSXME SPDR S&P Metals & Mining Index NYSE + BATSTIPS Bond Fund

The change above covers assets from inflation-linked U.S. Treasury bonds and “angel” bonds to mining and oil drilling companies. Angel bonds are bonds that were once higher-rated investment-grade bonds. The bonds lost their rating/were downgraded due to some sort of business stress. Given that they began at a higher rating, history shows that they often hold up better than bonds that were rated “junk” from the outset. Additionally, their move down from investment-grade to “junk” forces them to be sold en masse by many bond funds whose dictate is to invest in high-rated bonds. Thus, their prices can be hit harder than you might otherwise expect. They become bargains as a result, so the theory goes. (The ETF ANGL invests exclusively in this portion of the high-yield bond market.)

This change in trend from plunging “going out of business” to “future looks brighter!” results from the easing of recessionary fears in the U.S., a scenario which dominated trade in the painful first six weeks of the year. Additionally, it likely reflects some amount of confidence that the Chinese economy won’t crash. Those two factors plus a falling U.S. dollar (which supports commodity prices as we’ve shown recently) lead to improvement in emerging market currencies. We wrote a couple of weeks on this shift in the U.S. dollar and its impact.

Of course, whether this trend will hold up is anyone’s guess. Oil prices certainly have stabilized at a higher level as cuts in U.S. drilling have started to ripple through to production output a bit. This suggests that the surge in supply in recent years has been capped while demand remains in a relatively steady uptrend. Oftentimes, as we saw in January and February with the unfounded recessionary fears, markets are emotional beings following a scenario that doesn’t turn out to be true. Right now, that scenario is an easing in concerns about the global economy, a continued thesis that central banks have everything under control, and inflation will slowly ramp up (if only through commodity prices NOT falling further). The scenario has breathed life into assets that suffered heavily over the past several months and have served to keep stocks inching upward overall.

“Slow” series of signals turns bullish – maybe

The change in tone noted above has kept stocks moving higher over the past several weeks. This change in trend has lasted long enough to ripple through to some monthly signals. Chart 4 below displays a series of slower-moving monthly signals that are turning upward into bullish territory. Of course this occurs as the market revisits prior highs. So we will see if stocks can truly break to new high ground this time. The month of April would need to hold on in the remaining week to keep this series of signals having turned the bullish corner. But for now, it looks like a positive change.

Chart 4: Series of monthly signals turns bullish – will they hold on?

Series of monthly signals turns bullish - will they hold on?

Market Update

Investors came into the week wrestling with an overnight plunge in oil prices. The price decline occurred when a meeting of many of the major oil-producing nations resulted in no agreement. That drop in oil pressured stock prices early on. But buyers quickly stepped in to reverse the fall and send stocks to a healthy +0.7% advance while energy stocks reversed a -1.6% drop to a +1.6% gain. Oil and stocks moved further upward Tuesday with stock indexes climbing +0.3% though tech stocks fell back modestly. Strength in financial stocks helped keep the market’s win streak alive Wednesday with earnings supporting the higher prices. Stocks overall closed green though just barely so.
Behind the scenes was a sharp shift in favored sectors as Coca-Cola sold off hard after a disappointing earnings miss. Defensive sectors, consumer staples and utilities, which have been leading the market much of the year, came under notable pressure as investors appeared to move money out of these sectors and into the surging energy and material areas. Thursday ended the winning ways with a -0.5% fall in stocks as indexes wrangled with key overhead resistance levels. For example, the S&P 500 breached 2100 for the first time in months Wednesday. This level has marked the end of the road for prior rallies. So it was natural for investors to take pause here after the multi-week runup. Overnight earnings disappointments from a number of heavyweights – Microsoft, Alphabet, Starbucks, and Visa – kept stocks under pressure early Friday. However, strength in energy and industrial shares offered a counter-weight to the selling in the Nasdaq. The net result was a flat S&P 500 while the Nasdaq 100 fell more than -2% at the session’s worst levels.

Warm wishes and until next week.