Bond Market's Confidence Supports Stock Market Rally

The stock market's recent rally is receiving a vote of confidence from the bond market, as indicated by DataTrek Research. Nicholas Colas, co-founder of DataTrek Research, highlights that U.S. corporate bond spreads have tightened and are now on par with the levels seen between 2017 and 2019. This development bodes well for the continuation of stock market gains.

Colas explains that a decline in corporate bond spreads compared to similar Treasuries is a positive indication of increasing confidence in future cash flows and earnings. This trend is evident in both investment-grade and high-yield bonds, which have experienced tightening spreads over the past few weeks. Notably, these spreads have now reached average levels observed during the favorable economic conditions of 2017-2019.

According to Colas's research, investment-grade spreads were on average 1.19 percentage points higher than Treasuries during this time period, with junk bonds averaging 3.82 percentage points higher. These figures further reinforce the notion that the economy was generally performing well, with only a temporary setback caused by the Federal Reserve's rate policy hiccup towards the end of 2018.

The bond market's expression of confidence in company cash flows serves as a supportive signal for the current rally in the stock market. As it continues to tighten, this trend suggests that further gains may be on the horizon.

Investment-Grade and High-Yield Bond Spreads Narrow

According to a recent report by DataTrek, investment-grade and high-yield bond spreads have seen a decrease. The spreads for investment-grade bonds currently stand at approximately 1.22 percentage points, while high-yield debt spreads have narrowed to 3.78%.

Reflecting Confidence in Company Cash Flows

DataTrek's analysis shows that corporate bond markets are reflecting the same confidence seen in equity markets. The stability and strengthening of company cash flows are contributing to this positive outlook. It is worth noting that this trend has not only supported the ongoing rally in large-cap stocks but also helped small-cap stocks outperform in July.

Small-Cap Stocks Outshine Their Counterparts

FactSet data reveals that the Russell 2000 index, which tracks small-cap stocks in the U.S., has experienced a significant increase of 4.9% this month. In comparison, the S&P 500 saw gains of 3% during the same period. While the Russell 2000 has trailed behind the S&P 500 in 2023 with gains of 12.5% thus far, its recent performance indicates a potential shift.

High-Yield Bonds as an Indicator

Bespoke Investment Group also highlighted high-yield bonds as another indicator confirming the equity market's rally. The S&P 500, representing U.S. large-cap stocks, has already surged by an impressive 19.3% this year, as of Friday.

Positive Projections for the Future

In a research note, Citigroup analysts shared their optimistic outlook on the market. They raised their 2023 target for the S&P 500 by 600 points to 4,600 while revising their mid-2024 target to 5,000 from 4,400. This positive sentiment is reflected in the closing value of the popular stock-market index, which stood at 4,582.23 at the end of Friday.

Conclusion

The narrowing bond spreads suggest an optimistic outlook for the market. With the confidence in equity market returns and the positive performance of small-cap stocks, investors have reason to be encouraged. The projections made by Citigroup further support this positive sentiment moving forward.