Are the credit markets sending us a warning signal about our economic landscape?
Recall that in 2008 all but the safest assets (U.S. Treasuries) declined significantly in value. In a similar fashion in 2009 risk-based assets, both equities and bonds, have experienced a healthy rebound, albeit of varying degrees. Are we starting to witness a disconnect in this lock-step relationship?
I highlighted yesterday the recent significant downward move within the high yield bond space in writing “Everybody Out of the Pool.” I pointed out:
Within specific market segments, the one sector that has outpaced almost every other is the high yield space within the bond market. An ETF which I reference for market performance is COY. Prior to the recent selloff, this specific fund had risen almost 50% on the year. It has given back approximately 6-7% over the last few days.
The Wall Street Journal picks up on this theme this morning and reports, Some Wobbles for the Financial Markets’ Tandem Ride:
Since the nadir in March, U.S. stocks have gained close to 50% and investment-grade credit spreads have halved.
The two asset classes have rallied in tandem as panic over a financial collapse has dissipated. But with the focus now on economic recovery, despite Monday’s global stock-market selloff, a disconnect is developing.
Credit-default-swap indexes that usually move in line with equities have begun to follow their own tune, one with a more downbeat tone on the outlook. U.S. stocks hit new 2009 highs last week before losing some ground, while the investment-grade Markit CDX and iTraxx indexes underperformed sharply.
Even with a 0.6% decline on the week, the S&P 500 closed off the week’s lows, while the 0.12 percentage point widening in the CDX took the index back to a level unseen since July 24.
Equity investors appear focused on the surprising resilience of earnings and the potential for punchy profits if revenues rebound. Credit Suisse forecasts a 20% rise in 2010 S&P 500 operating earnings, giving the market a price/earnings multiple of just 14 times, below the long-run average.
Credit investors seem more concerned about how sustainable any recovery might prove, and are inclined to require more proof that demand is picking up. Cash bond spreads are now comparable to levels seen in the 1981-1982 and 2001 recessions, rather than at 1930s Depression levels. But defaults still are climbing and credit deterioration continuing.
Credit markets are concerned about consumer demand. A key driver for last week’s credit selloff was the disappointing U.S. retail sales number for July. Stocks seemed to shrug off that data when it emerged, focusing instead on strong corporate earnings, even though many results are being driven by cost-cutting exercises; witness Wal-Mart’s profits holding up while it missed sales targets.
With all due respect to equity managers and investors, I have always viewed the credit markets as a better indicator of market health and direction. Why? The credit market operates on the premise of an entity’s ability to service debt. As such, the credit market puts a greater discount on the accounting smoke and mirrors that are utilized to raise equity capital.
Is the recent price action in the credit market forecasting a problem on our economic landscape?