Many more investors seem to be coming around to the idea that economic growth is quite slow and that central banks have been completely ineffective in their efforts. Risk premiums have mostly gravitated higher this year to compensate for the increased economic uncertainty. However, stock indices (in contrast to many stocks) continue to levitate on the idea that monetary policy will come to the rescue, while most everything else reflects quite the opposite. Importantly, bad news will cease to be risk asset supportive when credit market participants become much more selective or completely reluctant to buy corporate bonds. We think we might be near that point just as Dell and Anheuser-Busch Inbev look to raise enormous sums to finance acquisitions.
The high yield bond market has become quite inexpensive relative to the S&P 500 in 2015. This cheapening process began with the collapse in the prices of oil and other commodities last year, which has taken place, in no small part, due to the rising dollar and slowing economies. This obviously hit the revenue of commodity producers. More broadly, the strong dollar is commonly hitting the revenues of many multi-nationals to the tune of 5-10% and that is adding to concerns and impacting earnings. Of course, few noted the positive effect of the weaker dollar on revenues earlier in the cycle during our QE phase, but now that other nations are conducting the same policy in obscene amounts, making the dollar richer, investors are either up in arms or dismissing the reversal of fortune as insignificant. Debt coverage measures look quite stretched in the resources sectors and their suppliers and problem credits are growing in number. Over time, credit spreads have widened across the board in many industries as downgrades have increased dramatically to the point that makes bond buyers skittish.
As we have said in prior letters, because of the gargantuan pace of issuance in recent years, the corporate bond market will be the center of the storm, much like mortgages were in the last cycle. It makes no sense that one can buy high yield corporate bonds at the more attractive spreads of 2010-11, while the large cap equity barometers are much richer than they were back then. After all, the corporate debt market has been even more important to equities in this cycle than in prior ones because many of the bonds issued have been used to fund the stock buybacks, which were much more impactful than anything the Fed has done.
We have not witnessed cathartic selling in stocks yet in spite of how uncomfortable many felt in recent months. The S&P 500 is still valued at about twice the normal price to revenue ratio or market cap to GDP metric. All judgements on equity exposure must reconcile with the tendency for these measures to mean revert and then some. That could prove quite unsettling for those who decide to bet that somehow, some way that index will become more extremely overvalued. It can happen quickly or slowly, but for analysts like us who use historical valuations as a guide, assuming that a return to rational valuations will not happen is a mathematically uninformed approach and thus quite risky.
Credit markets do lead stock markets. When those with the first claims on corporate cash flows begin to worry as expressed by wider bond credit spreads, even in the face of the perception that the Fed may remain easy, then stockholders must also discount greater risk by lowering share prices. We expect corporate debt to continue to follow the normal cyclical script and cheapen in 2016. We also expect the S&P 500 to cheapen versus credit markets. It is important to remember that the list of stocks down over 20% from their highs is quite high, so the foundation of the equity market is not exactly rock solid. If events follow the familiar pattern of past cycles, those maintaining equity exposures through index-oriented vehicles will lose conviction as the idea that a Fed less likely to raise rates also brings with it the reality that growth must be quite slow and risks increasing.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.