RQA Economic Insights: November 2023 — Richmond Quantitative Advisors

RQA Indicator Spotlight: Corporate bond spreads

In this month's analysis of economic data, we take a look at historical trends in corporate bond credit spreads. The bond credit spread, denoting the yield difference between AAA and BAA corporate bonds, serves as a critical gauge of investor sentiment and economic conditions. A widening credit spread, where BAA yields rise compared to AAA yields, signals increased risk perception in the corporate bond market and often precedes economic recessions. Conversely, a narrowing credit spread suggests optimism and confidence in the financial health of corporations.

Investors closely monitor this spread as a leading indicator of economic challenges, as denoted in the historical graphic detail below, recognizing its potential to provide early signals of downturns.

While it's important to also note that numerous factors influence bond yields, such as monetary policy and geopolitical events, the credit spread still acts as a valuable barometer, offering insights into investor confidence and potential economic shifts.

*Source: Data from U.S. Federal Reserve; Analysis by RQA.*

The widening of corporate bond spreads in the U.S. has historically been closely connected to a rise in volatility within the equity markets. As corporate spreads expand, indicating an elevated demand for higher yields due to higher perceived risks in the bond market, investors tend to adopt a more risk-averse stance. This heightened risk aversion often extends to the equity market, contributing to an uptick in overall volatility. The relationship between the widening of credit spreads and increased equity market volatility underscores the interplay between different segments of the financial markets and how concerns in one area can reverberate across others.

*Source: Data from U.S. Federal Reserve; NYSEArca - Nasdaq; Analysis by RQA.*

Currently, corporate spreads have eased since the March banking crisis, signaling a more stable and less stressed bond market. This indicator becomes particularly crucial as companies consider refinancing debt obligations in the context of an elevated interest rate environment.

In conjunction with the array of leading measures within the RQA Economic Model, corporate bond spreads continue to play a pivotal role in deciphering signals from the bond market regarding near-term economic growth concerns. Moreover, this insight remains valuable for anticipating potential implications for U.S. equity market volatility.

Economic Forecast Model

The RQA Economic Forecast Model moderated slightly to 0.28 in October, coming down from 0.35 in September. Though this move wasn’t in the positive direction, it remains a continuation of the recent state of the U.S. economy - meaning not much has changed from a fundamental forecasting perspective. Overall, the model’s positive trend remains directionally intact - however, we would like to see some incremental positive movement to further our conviction around a near-to-medium term growth outlook.

*Source: Analysis by RQA. Data from U.S. Federal Reserve; Bureau of Labor Statistics; Norgate Premium Data; Institute for Supply Management*

The RQA Economic Forecast Model represents a consolidated composite of key economic leading indicators and market-based explanatory variables. The goal of this composite model is to present a holistic measure of primary U.S. economic growth drivers and their trends over time. (Additional detail on the model’s construction is provided here.)

Values above the zero-line are indicative of positive U.S. economic growth expectations in the near-term, and therefore, indicate economic strength and lesser chance of recessionary pressure. On the other hand, values below the zero-line represent the opposite - a more negative outlook and more elevated probabilities of the U.S. experiencing an economic contraction.

TAKING A CLOSER LOOK AT THE ECONOMIC DRIVERS

In the economic heatmap below, we are able to peak under the hood at a wide mix of underlying growth drivers in the U.S. economy. By reviewing this underlying data in more detail, we are better able to see how the underlying components of the U.S. economic growth picture are behaving through time. The indicators presented below have each proven to have predictive qualities in estimating the future direction of U.S. economic growth.

In assessing the various metrics tracked by our economic forecast model, the key takeaways for the month are as follows:

U.S. labor metrics remain fairly robust, from both a rate-of-change perspective and absolute indicator readings - particularly as unemployment remains historically low;
The divergence between the U.S. goods economy (manufacturing/industrial production) and the services economy remains, as services sectors and related data continue to come in strong, while goods production data continues to experience weakness. That said, October signaled somewhat of a convergence within these two measures;
Income and consumption data also continue to exhibit modestly positive trends, yet retail sales continue to lag; and
Sentiment and market-based explanatory variables are continuing to show signs that investors are eyeing a “soft landing” and a re-emergence of growth in the economy, as equity markets continue to exhibit strength and corporate bond spreads continue to narrow.

MARKET REGIME DISCUSSION

In the past month, risk assets have responded favorably to the relief rally observed in the bond market, marked by a peak in interest rates followed by a subsequent moderation. Contrary to concerns that rising rates might instigate fear across equity sectors, the recent rate moderation has alleviated worries about contagion effects associated with higher rates. With equity markets anticipating positive year-end seasonal flows and a Federal Reserve that is presently refraining from additional rate hikes, the market continues to embrace the possibility of a “soft landing”.

While the overall economic forecast model continues to project growth in the near term, the noteworthy development has been the latest Consumer Price Index (CPI) reading, which slightly undershot expectations. Given that Fed reactions are influenced by CPI trends and the overall headline number, the primary focus is on the idea that prices will cool appropriately while the economy maintains its modest growth trajectory. On the contrary, a CPI dataset indicating a rapid decline (although not observed yet) could suggest a potential acceleration in the so-called “soft landing”. Key areas of attention include near-term trends within leading economic indicators, such as initial jobless claims, money supply, and the shape of the yield curve. These factors form the basis and collectively contribute to the RQA Economic Model.

Against the backdrop of moderate near-term growth and decreasing inflation, the overall quadrant analysis indicates a modest inflationary boom environment. As the narrative surrounding a potential “soft landing” gains momentum, it is crucial to maintain focus on where the data is leading in terms of near-term growth signals. This vigilance ensures that the landing speed isn't accelerating, especially as the market tends to become more complacent.