What Are the Credit Markets Telling Us?

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?

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

Visit: Sense On Cents

Be the first to comment

Leave a Reply

Your email address will not be published.