Different Market Signals

Telemus Weekly Market Review April 3rd - April 7th, 2023

In what has now been a month since the failure of Silicon Valley Bank, markets have gyrated as they look to reprice risks associated with bank liquidity, rising odds of a potential recession, and future actions out of the Federal Reserve. What we have seen over the course of the past month is an inconsistency across components of the stock and bond markets that indicate different perspectives on the risks ahead.

Since March 8th, the day before the mass run on Silicon Valley Bank occurred, yields on Treasury bonds have plummeted. Two-year Treasuries yield have dropped over a full percentage point, while ten-year Treasures where yields have had a more moderate decline of 0.61%. A key factor driving the decline in two-year Treasuries is an increased expectation that the Federal Reserve will not only soon stop hiking rates but that they will even begin cutting rates later this year. The sudden expectation for looming rate cuts stems from tighter lending conditions by banks, which some project may push the U.S. economy into a recession. 

This viewpoint is contrary to the action of stocks, where the S&P 500 has returned 3.0% since March 8th. Stock prices have steadily climbed and now sit at above average valuations relative to their expected earnings. Those valuations assume that earnings expectations don’t fall from here. If stocks were to take their cue from the Treasury bond market, one would expect a recession to negatively impact the sales and earnings of companies and therefore earnings expectations should go lower. However, if we peer more deeply into the equity market, the reason stocks are higher over the past month is that the largest stocks in the index (Apple, Microsoft, Amazon, Alphabet, and NVIDIA) have all experienced either high single-digit or low double-digit price moves over this time. This is impactful to returns given the nuance in the way the S&P 500 is comprised where it gives greater weight to larger stocks. In contrast, the S&P 500 Equal Weight index, which represents the return of the average stock regardless of size, is down 2% since March 8th. As we look at this divergence it’s clear that investors have been electing to migrate toward the largest stocks as they are being viewed as offering greater safety. 

If we turn to corporate bond market, it is pricing in risk levels that are more in the middle of Treasuries and stocks. Corporate bonds often trade off spreads. Spreads are the difference in the yield earned on a corporate bond relative to the yield earned on a comparable maturity Treasury bond. The spread is effectively the compensation an investor receives for taking on the risk that that corporate bond may default. High yield corporate bonds, for example, currently trade with spreads around 5.0% above that of a comparable Treasury. Prior to the Silicon Valley Bank failure, spreads where closer to 4.0%. High yield spreads, during market extremes, can get as high as 10% so current levels are far from extreme. In fact, a spread of 5.0% is roughly in line with long-term averages. Thus, while high yield bond markets have prices in more risk, we don’t believe they are incorporating the risk of a recession or more challenging economic conditions from corporate borrowers. 

The current investment landscape is dynamic, and investors are best suited if they understand what is being priced into the markets. Listening to presentations by members of the Federal Reserve Open Market Committee this past week, it remains less certain what the Fed’s path is from here. Leaning on any one particular outcome doesn’t seem prudent to us at this point, but we also believe it’s sensible to recognize where risk is and is not being adequately priced into the market. We expect markets to continue to evolve as we see further economic releases along with first quarter corporate earnings reports, which we will start seeing trickle in late this coming week. 

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