The Dog That Didn’t Bark

What was a unique feature of the recent stock market sell-off?

Give yourself a prize if you said the limited action in the bond market, especially high-yield and corporate bonds. High-yield bonds are correlated more with equities than with government bonds, so when stocks have a correction, there’s usually a jump in high-yield bond rates.

More importantly, the spread between the interest rates on high-yield bonds and those on treasury bonds increases, indicating that investors perceive the high-yield bonds to be riskier than before the correction.

In fact, the spike in the spread between interest rates on high-yield bonds and those on treasury bonds usually is significant and precedes a stock market correction. Investors in the credit markets are the first to be concerned about growth and the economy. Once the spread between high-yield bond rates and treasury rates widens, stock investors become concerned.

This time, there was an increase in the spread between high-yield bonds and treasuries, but it wasn’t significant. The spread increased only 0.59 percentage points, which is a fraction of the increase associated with previous corrections.

Also, the increase in the spread wasn’t consistent across the high-yield market. Spreads still are near their lows for the year in industry groups such as capital goods and chemicals. However, 12 of the 42 industry groups had their spreads widen by more than the high-yield average. Energy and environmental groups had the largest increase in spreads.

One element of the traditional scenario was in place. Investors sold high-yield bonds. In the week closing Feb. 14, investors took a net $10.9 billion from high-yield bond mutual funds. That’s the second-highest weekly outflow on record. There also was a large outflow from investment-grade corporate bonds.

Despite this large outflow of funds, the spread didn’t spike nearly as much as in the past, and high-yield bonds didn’t lose a lot of value. High-yield bonds declined, but not by as much as analysts expected given the outflow from the sector. For example, the iShares iBoxx High Yield Corporate Bond ETF (HYG) lost 1.17% over the last four weeks, while the S&P 500 lost 3.21%.

I conclude from this is that the stock market sell-off was not related to concerns about economic growth. In fact, investors see growth accelerating and earnings exceeding expectations, probably because of tax reform, deregulation and other factors. Concerns about the economy would be displayed in a rapid increase in the high-yield/treasury yield spread.

Most likely, some investors decided to take some profits and rebalance their portfolios. Others decided that the recent rise in treasury interest rates was a good reason to adjust the prices of stocks. Somewhere in the future are a recession and significant stock decline, but it’s likely that, as in the past, we’ll have an early warning from a sharp increase in the spread between high-yield and treasury bond rates.

The Data

The economy is humming, according to the PMI Composite Flash Index. The manufacturing component of the index increased to 55.9 from 55.5. That was better than expected and indicates another jump in the manufacturing sector. The services component of the index increased to 55.9 from 53.5. That’s a six-month high and marks a sharp recovery from some recent weakness.

The index of Leading Economic Indicators from The Conference Board increased 1.0%. That’s the fourth consecutive monthly increase, and the largest increase in three months. Eight of the 10 indicators were positive. The index reflects January’s data, so it doesn’t include the stock correction in February.

The new homes industry continues to improve. Housing starts increased at the second-highest rate since the financial crisis, and last month’s number was revised higher. Both single-family and multi-family homes participated in the increase. Permits for both types of housing also increased, indicating more starts in the coming months.

Existing homes didn’t do as well last month. Existing home sales declined 3.2% for the month, following a 3.6% decline last month. Over 12 months, sales are down 4.8%. One factor involved in the low sales is the low inventory of homes for sale, which remains near 19-year lows. Prices declined 2.4% for the month but are up 5.8% over 12 months.

Consumer Sentiment, as measured by the University of Michigan, still is positive. The index rose to 99.9 from 95.7. That’s the second-highest level in 14 years, bested only by last October’s reading.

New unemployment claims declined by 7,000, once again bringing both the weekly number and four-week average near the record lows.

The Markets

The S&P 500 inched up 0.17% for the week ended with Wednesday’s close. The Dow Jones Industrial Average lost 0.38%. The Russell 2000 returned 0.72%. The All-Country World Index dropped 0.05%. Emerging market equities gained 0.25%.

Long-term treasuries fell 0.79% for the week. Investment-grade bonds declined 0.21%. Treasury Inflation-Protected Securities (TIPS) lost 0.15%. High-yield bonds rose 0.41%.

The dollar recovered 1.29%.

Energy-based commodities returned 0.62% for the week. Broader-based commodities lost 0.08%. Gold dropped 2.08%.

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