High-Yield Credit Spreads Suggest That Investors Remain In 'Risk Off' Mode

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(Thursday Market Open) Investors are poised to take another run at those March lows because S&P 500 futures are pointing to a higher open. However, China’s declaration of victory over COVID-19 in Shanghai should remove some supply chain clogs.  

Potential Market Movers

The Shanghai Composite rose 0.42% while Americans slept, and the BSE Sensex also rose 0.79%. However, the Hong Kong Hang Seng fell by 1%. While the reopening of Shanghai should help with supply chain issues, particularly for American tech companies, it could also result in higher demand for oil as Shanghai citizens get back to work. So far this isn’t a problem because WTI crude oil futures were down 2.87%.

However, OPEC+ meets today to discuss what to do with the Russia situation. OPEC+ is expected to add some extra production to help offset some of the losses due to sanctions on Russia, but it isn’t expected to kick Russia out of the organization.

Last Friday, investors took the S&P 500 (SPX) up to its May and March lows around the 4,150 level but haven’t been able to break past resistance this week. Rising yields have been part of the problem as the 10-year Treasury yield (TNX) has risen from 2.743% to 2.931%. This morning the TNX had fallen nearly 3 basis points in early action.  

Despite earnings seasons all but wrapped up, there are several earnings announcement this morning moving some stocks.

• Food producers Hormel HRL and Sanderson Farms SAFM reported better-than-expected earnings and revenues, causing both stocks to rise in premarket trading at 0.40% and 1.15% respectively.
• Hewlett Packard HPE missed on top- and bottom-line numbers after Wednesday’s close leading the stock to fall nearly 4% near the open.
• NetApp NTAP met revenue estimates but soundly beat on earnings,  prompting a 3.3% rally overnight.
• Chewy CHWY pulled out a surprising profit instead of the loss analysts had expected, sparking a 20% rally in premarket action.
• GameStop GME reported a bigger loss than expected despite beating on revenues but only fell 0.53% ahead of the open.

JPMorgan Chase JPM CEO Jamie Dimon reversed his outlook on the economy. About a week ago, he was telling investors at JPMorgan Investor Day that things were looking better. However, in a talk to analysts and investors Wednesday, he said he sees a hurricane ahead. He also expressed doubt that the Fed can manufacture any type of soft landing. On the bright side, he did say that he felt the banking industry was in great shape to handle whatever comes.

The ADP Nonfarm Employment change was lower than expected as the economy added 128,000 new jobs, well below the forecast of 300,000 and lower than the April number of 202,000. S&P 500 futures fell immediately on the news, but the selloff was short-lived. During the pandemic, the ADP report struggled to be a reliable predictor of the Employment Situation Report that is due out this Friday.

The Bureau of Labor Statistics also reported productivity and labor costs before the opening bell. Productivity continues to fall but Q1 productivity wasn’t as bad as expected. However, labor costs were higher than expected for the quarter, rising 12.6% instead of the forecasted 11.6%. This is likely to be a concern for Federal Reserve policymakers as well as companies trying to deal with higher input costs.

More evidence of a weaker economy appeared in auto sales for May. Nearly every auto manufacturer saw double-digit sales declines. Mazda of North America saw sales plummet 63.7% year- over-year, while America Honda HMC dropped 57.3% and Toyota (TM) fell 27.4% globally and 27.3% in North America.

Reviewing the Market Minutes

For the third trading day in a row, the S&P 500 (SPX) failed to break above its March lows to resume its rally from last week.  The Dow Jones Industrial Average ($DJI) had a similar result as it also tested March lows. Additionally, the Cboe Market Volatility Index (VIX) tested the 25.5 level and failed to go lower. If last week’s rally is going to return, these levels will have to be broken.

Unfortunately, rising yields are likely to make this difficult. The 10-year Treasury yield (TNX) rallied nearly nine basis points to 2.931%. Over the last five months, higher yields have prompted stock revaluations and pushed the major indexes lower. The revaluations hit consumer discretionary and technology stocks hardest. However, the technology sector was one of the strongest sectors on Wednesday and the consumer discretionary sector finished in the middle of the pack. Additionally, the S&P 500 Pure Growth Index and the S&P 500 Pure Value Index finished nearly even with the growth index falling 1.2% and the value index tumbling 1.1%.

However, Treasury markets are likely to experience increased volatility as the Fed begins to unwind its balance sheet this month. Without the Fed replacing their maturing bonds, the Treasury market is less likely to find liquidity, which could push yields higher.

Rising yields appeared to cause the U.S. Dollar Index ($DXY) to rally as well. The dollar has pulled back over the last week, which has taken some of the pressure off of multinational corporations being hurt by currency headwinds. However, a stronger dollar is likely to be a drag on these stocks if it continues to rally.

The energy sector was the strongest with the Energy Select Sector Index climbing 1.79% and staying above its long-term resistance level near 900. Crude oil futures traded higher most of the day but gave up much of their gains to close 0.4% higher. Meanwhile, natural gas futures surged 7.65% and nearly regained their losses from Tuesday.

AAA recorded a new record for the average gas price in the United States at $4.67 a gallon. Seven states now average gas over $5 per gallon and New York and Arizona are not far behind. Californians are paying an average of $6.19 per gallon.

Meta Platforms (NASDAQ: FB) fell 2.6% following the news that chief operating officer Sheryl Sandberg is stepping down to focus on other interests. However, she will maintain her position on Meta’s board of directors. 

Three Things to Watch

Giving Credit: The ICE BofA U.S. High Yield Index tracks the credit spread. Not to be confused with the multi-leg options strategy, the credit spread measures the difference between high-yield bonds and Treasury bonds. When investors are feeling risk averse, the credit spread will widen because the yields on high-yield bonds will rise, possibly enticing investors away from the safety of Treasury bonds. When the spread narrows, it suggests that investors are in “risk on” mode because they’re favoring the higher potential of high-yield bonds over Treasuries. Greater demand for high-yield bonds pulls their yields closer to Treasury yields.

In the last few months, the credit spread has widened, which suggests that investors are still in “risk off” mode. Historically, the Fed has tried to avoid raising rates when the index is rising. With the Fed unloading its balance sheet, longer term Treasury yields may rise which could entice bond investors into the safety of Treasuries causing he spread to widen further.

Upper Crust: While many retailers have struggled recently with higher input costs and lower sales, luxury goods retailer Capri Holdings CPRI reported better-than-expected earnings and revenues. The owner of labels like Versace, Jimmy Choo, and Michael Kors rallied 1.64% despite offering a lower earnings outlook. Companies that cater to upper-income shoppers have fared better than their cohorts. Last week, high-end retailer Nordstrom JWN and luxury homebuilder Toll Brothers TOL both rallied after better-than-expected earnings reports. However, this hasn’t been categorically correct for all luxury companies as the S&P Global Luxury Index has fallen about 25% from its November high.

Also, last week’s personal income and savings report revealed that the savings rate has continually declined from 8.7% in December to 4.4% in April which is lower than pre-pandemic levels and on par with savings rates before the dot-com and credit crisis crashes. Additionally, real disposable personal income has declined every quarter since Q1 of 2021.

‘K’ Recovery: After the COVID-19 market crash and economic slowdown in 2020, many speculated if there would be a ‘V’ recovery where the market and the economy snapped back quickly. Others projected a ‘W’ recovery that would take more time. However, the ‘K’ recovery occurred where the upper class and the upper-middle class felt relatively little financial setback because their jobs allowed them to continue working, usually from home. Meanwhile, lower income workers were forced to take time off without a paycheck to avoid infection and spread. Despite extended and enhanced government unemployment benefits, lower-income workers struggled to enjoy the same recovery as higher-income earners did.

Even as the majority of Americans are no longer hindered by COVID-19 restrictions, the struggle to get ahead continues for many Americans as they go through their savings to focus on staples instead of luxuries.

Notable Calendar Items

June 3: Employment Situation Report, ISM Non-Manufacturing PMI, and earnings from CrowdStrike CRWD and DocuSign DOCU

June 7: U.S. Trade Balance and earnings from J.M Smucker SJM, Verint Systems VRNT, and Cracker Barrel CBRL

June 8: Earnings from Campbell Soup CPB

June 10: May Consumer Price Index (CPI) and preliminary University of Michigan Consumer Sentiment Index Results 

TD Ameritrade® commentary for educational purposes only. Member SIPC.

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.