On Monday, February 5^th the US equity market experienced its first 5% drawdown in 405 days. Three days later equities reached a 10% drawdown, which hadn’t occurred in almost two years. Market participants are now processing this move in real-time. Experts stand on both sides of the spectrum – some calling for a further correction, while others advise to “buy the dip” as the move this week is being deemed to be detached from fundamentals.

So why is this happening? In our view, there is no single cause, but a confluence of circumstances and events. Crowded positioning and bullish sentiment laid the groundwork. And, while economic growth and corporate fundamentals are strong, valuations fully reflect the underlying positive conditions. Here are the key events over the past two weeks that have stirred up market volatility:

• Bond yields rose after the US Treasury announced increased bond issuance on January 31^st in response to a larger budget deficit. In addition, the current administration’s announced plans for increased defense and infrastructure spending are expected to result in even more Treasuries issuance.
• Wage data released last week surprised to the upside giving rise to fears of an overheating economy in which inflationary pressures may drive central banks to tighten financial conditions further and slow the current growth cycle.
• On February 5^th, the VIX index spiked 20 points which is the sharpest rise ever for the index. Many investors, especially those with strategies linked to volatility, were caught off-sides and rushed to de-risk which exacerbated the correction throughout the week.

So what now? While we think technical selling ultimately subsides in the near-term, we believe that a period of higher volatility is here to stay. Below, we address the four most important questions for macro investors looking forward.

• Growth: How is the economy doing? Amid this month’s turmoil, economic data and corporate earnings continue to surprise to the upside. Tax reform should provide a boost to the corporate sector and consumption. The synchronous global growth conditions haven’t changed.
• Policy: Are central banks tightening or easing conditions? Central banks have taken notice of the strong economy, and have increasingly adopted a tighter stance as conditions have improved. However, we do think that concerns around financial stability and increased Treasury issuance provide a counterbalance to central bank tightening. We have not yet seen a desire for policymakers to respond to recent market developments. It goes without saying that an exit from global QE will be tricky. No matter your age, no one has experienced an exit from QE of this scale.
• Valuation: What is the market’s pricing of economic conditions? Given growth conditions and policy expectations, we think valuations are key. Global equity valuations fully reflected the positive side of strong growth and a healthy corporate sector. The markets are now adjusting to the reality of balancing the downside of strong growth and the end of QE. The rates market has priced in three rate hikes for 2018, and nearly two for 2019. The market is fully expecting the Fed to reach its rate targets.
• Sentiment: What is the prevailing market psychology? Market participants were euphoric in January, and after the recent move, sentiment has reverted to a normal level. January saw the largest inflows ever into equity ETFs (+$62 billion) and February is now seeing the largest equity ETF outflow on record ($30+ billion). The American Association of Individual Investors survey signaled extremely bullish sentiment in January. This week’s report showed a drop in sentiment back to more normal levels.

Undoubtedly, we know this year will not be like the last, where virtually all markets moved higher with little volatility. We’ll continue to assess the macro developments through our framework of Growth, Policy, Valuation, and Sentiment. This framework should serve our clients well in navigating the volatility ahead.

 

Source: Bloomberg. This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Technical indicators can be a useful tool for bond managers, particularly when combined with traditional fundamental/valuation methods and good old fashion macro research. In this piece, we address what the technical indicators are telling us about the potential path of the 10-Year Treasury yield.

From a technical perspective, the 10-Year Treasury yield is testing the three-decade long secular bull market resistant trend line of 2.63%.  Barring another false breakout, a break of 2.63% would put yields in a technical gap that could move yields up to a 3.00% very quickly. In this environment, diversification and active management are the keys to success for bond investors.

The chart below illustrates that the long-term trend line of 2.63% (orange line) is close to intersecting the Fibonacci resistant level of around 2.61% (grey line). Fibonacci levels tend to be well respected support/resistant areas where a break-out occurs or serve as the proverbial line-in-sand that does not get crossed. Historically, once the trendline is broken though, a reversal pattern becomes a higher probability event.

Although a trend change in the 10-Year Treasury yield may sound frightening to bond investors, the technical charts provide a well contained, and range-bound, move in the 10-Year yield if the long-term resistant level is broken.  If broken, the 3.00% level is not only supported, but also coincides with where the 5-year average real rate indicator suggests the 10-year rate should be.

As referenced in the chart below, although a sharp rise of the 10-Year Treasury has historically exhibited negative performance for the 10-Year Treasury, a well-diversified portfolio of bonds, as represented by the Barclays Aggregate Index, has performed quite well in those environments.

Additionally, active management through duration tilting and curve positioning are tools to limit, or even benefit from, the effects of rising rates. In addition, prudently adding spread product can potentially offset a rise in rates as spreads tend to be more stable and offer addition interest income carry.  For Sage clients, one of the major benefits of active fixed income management continues to be adjusting portfolio characteristics to maximize returns in any interest rate environment.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Several of the technical/sentiment indicators we monitor are suggesting equities may be getting stretched. One indicator in particular caught our eye. The American Association of Individual Investors Bullish/Bearish Sentiment (below) reached a multi-year high last week signaling extreme bullish sentiment toward equity markets among individual investors. The current reading is a standard deviation above the norm (on a 4-week moving avg. basis), suggesting investors have become too bullish and begging the question, are we in for a correction near-term?

We dug into what this level has meant in the past for investors, at least over the last 13 years. This level has been hit three times previously since 2005. In all cases markets experienced some volatility and small drawdowns ranging from 1%-6% at some point during the following three month. However, in all three cases the S&P 500 Index was higher three months later, by an average of 3.3%. Bottom line, we are likely to get a small/medium correction soon, but given the fundamental picture, it would not be the start of something larger.  And, if the correction is greater than 10%, we would likely consider it a good buying opportunity.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Bond market observations from the Sage portfolio management team.

The recent shift higher in front-end rates domestically was felt abroad, as well. U.S. 2yr Treasuries have risen nearly 30bps since the beginning of November. In that same timespan, German and French 2yr yields have risen by approximately 10bps. The trend towards tighter monetary policy is not isolated to the United States, as Mario Draghi and the ECB will continue removing accommodation through 2018 with an expectation their quantitative easing program will end in September 2018. Sovereign yields responded accordingly by drifting higher.

Something else that caught our attention is how the real yield story is evolving domestically and abroad. Looking at the differential of US and German 5yr real yields vs. the Euro shows how currency moves are tracking real yields. As German real yields have shifted lower over the last year and U.S. real yields have moved higher, the Euro has strengthened. This currency strength could be signaling investors’ anticipation of higher sovereign real yields.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.