The recent all-time highs in the Dow, S&P 500, and NASDAQ all conjure visions of robust capital markets and a bustling economy. Certainly, the major equity indices, with all of their flaws and blemishes (e.g., overweights in large cap tech distorting overall market health) have performed better than most anyone would have expected back at the dawn of the pandemic in March.
By most measures, the economy is still struggling in “risk-off” mode with still high unemployment at 6.7%, depressed oil prices at $45/bbl, industrial production (NAICS) just over 101 (compared to 106 in February), and weak consumer sentiment of 81.8 (compared to 101 in January). Partly offsetting those weak stats is some hopeful prospects from the Conference Board Leading Economic Indicator showing a 0.7% increase in October pushing the index to 108.2; a healthy level that is closing in on the 112 level seen in January 2020.
Another favorite measure of mine is the credit spread level of the high yield bond index (see chart below). As we know, this indicator cratered in March 2020 at the dawn of the pandemic with credit spreads spiking to 10.87% (1,087 basis points for the bond gurus out there!) We have seen these spreads come in significantly since then due to dramatic action by the Fed, including the outright purchase of bonds and bond ETFs and fiscal stimulus spending. High yield spreads currently sit at 4.03% (403 basis points); a recent low since March.
Historically, bullish periods for high yield bonds track down to normalize around a 300 basis point credit spread like we saw in 2014 and 2018. Are we headed there now? It is certainly possible, but no telling if there is enough oomph left in the recovery arsenal to get us there. No reason to abandon high yield bonds at this time since a long term allocation to this risky asset class historically outperforms less risky bond sectors.