Indexology^® Blog

As we reflect on this year’s notable market themes, one trend is certain: it has been a tumultuous market characterized by rate hikes and inflation concerns across regions, with significant losses across asset classes. Crypto market performance added to jitters, with the S&P Cryptocurrency LargeCap Index down 66% YTD. Losses throughout the year culminated in the collapse of FTX, one of the largest global cryptocurrency exchanges, as a result of its founder’s recent fraud allegations. A turnaround in broad market equities that began in October provided much-needed relief, with easing inflation and optimism surrounding a potential slowing pace of U.S. rate hikes, but the S&P 500^® has still declined by 15% YTD.

Meanwhile, U.S. Treasuries are on track for their worst year on record, with the S&P U.S. Treasury Bond Index down 9%. As a result, correlations between U.S. equities and bonds turned positive, which last occurred during the second quarter of 2021, as Exhibit 1 illustrates. Corporates and high yield bonds also suffered, with the iBoxx USD Liquid Investment Grade Index and iBoxx USD Liquid High Yield Index down 15% and 8%, respectively. The combined underperformance of equities and bonds meant record losses for the traditional 60/40 portfolio. Other regions were not spared, and the U.K. bond market downturn taught us the importance of liquidity, which can be hard to find when it most needed. Another consequence of rising rates along with safe-haven demand globally was the rally in the U.S. dollar.

Investors’ search for income led to renewed interest in dividend and low volatility strategies, with the S&P 500 Low Volatility High Dividend Index significantly outperforming the benchmark. Additional safe harbors came from value strategies, which have outperformed growth in the U.S. and globally after decades of underperformance. After years of mega-cap dominance, further reversals came with the strength of smaller caps, boosting the performance of S&P 500 Equal Weight Index.

Emerging market equities offered little solace, with the S&P Emerging BMI down 17% YTD, although a rebound in the final quarter was aided by optimism in the U.S., a pullback in the dollar and especially the rebound in China equities as a result of the potential move away from strict pandemic policies. The swings in Chinese equity performance make their diversification properties interesting to analyze. In Exhibit 2, we calculate the spread in trailing 12-month volatility between the S&P Emerging BMI versus S&P Emerging Ex-China BMI. When this spread is positive, the inclusion of the country increases volatility in the benchmark; when negative, the country acts as a diversifier. Note the positive spread for China since March 2021, highlighting China’s switch from a volatility diversifier to a volatility amplifier, as the country’s fortunes have increasingly been tied to the rest of the emerging markets.

Unsurprisingly, as macro headwinds whipsawed markets, volatility rose.  Index dispersion remained elevated, potentially leading to relatively better U.S. large-cap fund outperformance in the first half of the year by creating greater opportunities to add value from stock selection. Volatility also manifested itself in the rising differences among global sectors and countries that we see in Exhibit 3, which implies greater potential opportunities to add value from sector and country allocation. The S&P Global 1200 Energy led among sectors with a YTD gain of 46%, driven by the surge in oil prices from supply shocks, including the Russia-Ukraine conflict and companies’ increased willingness to participate in the energy transition. In contrast to China, Energy, despite being the most volatile sector, has acted as a volatility diversifier.

As uncertainty over the future global economic outlook lingers, with concerns around Q4 corporate earnings, a record inversion between 2- and 10-year Treasury yields, alongside a backdrop of geopolitical tensions, forecasting the market outcome for 2023 may be a futile exercise. But a couple of silver linings are worth noting: the torrid losses in fixed income have made bonds more attractive with relatively high current yields, particularly in the emerging markets and high yield space. As far as equities are concerned, U.S. history might offer a glimmer of hope, with Exhibit 4 showing that since 1936, of the nine prior years with double-digit losses, seven of those years experienced double-digit gains the following year, proof that the best guess of future returns does not depend on the immediate past.

With the ZIRP world¹ firmly in the rear view, the “income” in fixed income is back. As yields collapsed to record lows, income-starved investors sought alternative sources of income such as dividend strategies, which attracted record flows in related products throughout 2022. Now, with investment grade bond yields hitting as high as 6%, bonds are back to offering compelling income opportunities.

In addition to enhanced income, we analyze common risk signals such as credit spread, liquidity and interest rate risk to assess the current state of the bond market. Placing index attributes in a historical context, risk factors indicate stabilizing spreads and liquidity with declining interest rate risk in the broad indices. Lastly, we compare bond yields to alternative sources of income, with higher breakeven inflation yields offered in Treasury bonds compared to dividend yields in the S&P 500.

After more than a decade of investment grade corporations paying an average of 3.6%, and never more than 5%, yields on the iBoxx $ Liquid Investment Corporate Bond Index reached as high as 6.31% this summer, a nearly 4 standard deviation move from its 10-year average, before settling in the mid-5% range. While 3 standard deviation moves are rare, a move of 4 standard deviations enters “black swan” territory. Simply put, investment grade bond yields have not been this high since the aftermath of the credit crisis. Further, the spreads offered in excess of Treasuries by the iBoxx $ Liquid Investment Grade Corporate Bond Index are trading around the 10-year average of 150 bps and far from the 380 bps seen during the COVID-induced sell-off, suggesting historically high yields are not a result of degrading credit quality and the impact on rising rates is contained to the Treasury market.

During times of stress, volatility can adversely affect liquidity, particularly in fixed income. Treasury market liquidity has declined by an average of 0.1 bps of yield this year compared to 2021. The average bid/ask yields of the iBoxx Treasury Bond Index YTD rose to an average of 0.45 bps from 0.35 bps in 2021. Conversely, the liquidity of the iBoxx $ Liquid Investment Grade Corporate Bond Index has remained relatively stable by virtue of the index methodology selecting the most traded bonds, with the average bid/offer spread well below pandemic highs, an advantage magnified during stressed markets.

While current yields appear attractive on a historical basis and relative to dividends, potential risk remains inherent in fixed income. A bond’s sensitivity to rising rates is best measured through its duration, for every given unit of duration magnifies the negative impact on prices when yields rise. Throughout the pandemic, corporate officers took advantage of low borrowing costs to raise debt and extend the duration of their loans, thereby extending overall index duration and increasing sensitivity to interest rate increases. As borrowing dropped and debt supply dropped, duration fell back to historical levels. The iBoxx $ Liquid Investment Grade Corporate Bond Index duration has shed by over a year in 2022 and is now slightly below its long-term average. With a lower duration profile, the index is less sensitive to potential rate shocks going forward.

When compared on a real (inflation-adjusted) basis, it appears bonds are offering income well in excess of those offered by many stocks. The S&P U.S. TIPS 10-Year Index represents the real yield offered by the market. Indicative dividend yields of stocks in the S&P 500^® are at their lowest level in at least a decade, while the yield premium of IBOXIG yields are their highest in at least a decade.

As the Fed combats inflation to stabilize the economy, assets including fixed income and growth stocks are adversely affected. While many have flocked to dividend strategies, fixed income remains attractive as a traditional, non-alternative, source of income. Improved liquidity through proper index construction, combined with declining interest rate risk, can potentially reduce risks that plagued previous time periods. Bonds may be back, and through an index lens, are looking better and better.

¹ ZIRP refers to global central banks pursuing a zero-interest rate policy (ZIRP)

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Football fanatics across the globe are watching closely to see which of the 32 countries that qualified for the FIFA World Cup finals in Qatar will raise the trophy in glory.

Every four years, the global spotlight scrutinizes each nation’s footballing prowess (or lack thereof). Beyond coaches, pundits and tacticians, the World Cup gives plenty of fodder for social scientists, economists and even political theorists to analyze and attempt to identify trends or patterns that may contribute to World Cup success.

If tournament success were down to population size, China and India would have surely won the cup by now. If the economy size or GDP per capita were a meaningful metric, then the U.S., Luxembourg or Singapore would surely have come close to winning the coveted cup by now. The countries topping the UN’s Human Development Index (Switzerland, Norway and Iceland) haven’t won a World Cup either. In fact, a number of these notable mentions rarely qualify for the finals.

S&P Dow Jones Indices (S&P DJI) certainly does not purport to have isolated the secret ingredient for World Cup success, but we do know indices and are keenly following competing countries that are included in the S&P Global BMI (Broad Market Index) and S&P Frontier BMI.

S&P DJI Market Classifications

The S&P Global BMI consists of 49 markets, of which 25 are classified as developed and 24 as emerging, while the S&P Frontier BMI consists of 31 additional markets. The S&P Global BMI comprises over 14,000 companies and covers all publicly listed equities with float-adjusted market values above USD 100 million that meet minimum liquidity criteria. The S&P Frontier BMI is designed to measure the performance of relatively smaller and less liquid markets.

Of the 32 countries that have qualified for the 2022 World Cup finals, 20 are included in the S&P Global BMI, covering 87.7% of the index’s market capitalization; 15 of these are considered developed, while the other 5 are emerging. Seven other competing countries are represented within the S&P Frontier BMI, covering just over a third of the index’s market capitalization, while the remaining five qualifiers do not currently meet frontier market criteria.

Developed Markets Have Better FIFA Rankings

Looking at the average FIFA ranking of each segment, the developed cohort has the lowest at 15.8, followed by the countries not classified in S&P DJI’s global equity index series at 25.8. Despite having the top-ranked nation (Brazil), the emerging cohort’s average rank is 28.2, which is higher than the frontier cohort at 27.1.

Developed Markets Overrepresented at the World Cup Finals

FIFA membership consists of over 200 nations and associations, and only 25 of those are classified as developed markets by S&P DJI. However, these nations¹ represent over 40% of the countries (15 of 32) that qualified for the 2022 finals and over 60% of the teams that progressed to the round of 16.

Since the S&P Global BMI launched in 1989, there have been eight World Cup finals, two have been won by an emerging market—Brazil—and the other six by countries classified as developed markets—Germany, France, Italy and Spain.

While Brazil is the favorite to be in the World Cup Final on Dec. 18, 2022, form aside, it seems that countries from the developed markets cohort will have the highest likelihood of World Cup success. While the frontier cohort has bucked the trend outperforming emerging.

Notable Outperformers and Underperformers

Given each country’s stature in the S&P Global BMI by composition weight and number of companies, Canada, Germany and Denmark would be seen as underperformers in terms of global market stature and footballing prowess by not progressing beyond the group stage at this year’s World Cup.

While Argentina, Brazil and Croatia have outperformed their market stature, they are highly placed in their FIFA rankings—so this isn’t unexpected. Surprising outperformers would be Morocco, Ghana and Senegal based on their limited investable market stature.

S&P Dow Jones Indices Market Classification Methodology can be found here: https://www.spglobal.com/spdji/en/documents/index-policies/methodology-country-classification.pdf.

¹ The U.K. is classified as one developed market but represented in multiples associations within FIFA—England, Northern Ireland, Gibraltar, Scotland and Wales.

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