LONDON (Reuters) - Credit markets lead equities, or so the maxim goes. If true, stock markets are in for a bumpy ride for the rest of the year.
The Dow and S&P 500 have regained their footing in recent months and are back within touching distance of the record highs reached in late January. The Nasdaq has powered on to new peaks.
But the deterioration in corporate credit markets continues unabated.
U.S. non-financial corporate debt totals are at the highest on record, both nominally and as a share of GDP. While default rates remain low, the prospect of the Federal Reserve extending its long, if shallow, cycle of interest rate rises will almost certainly see those increase.
Fed tightening has put U.S. credit, especially investment grade, under pressure. Total returns for the IG corporate bond index year to date declined 3.4 percent, and are on course for the worst year since 1996, notes Morgan Stanley.
Rising rates and bond yields, plus widening credit spreads, have pushed the U.S. investment grade index down to $100 in price, the first time it has traded at par since 2009.
Emerging markets are also vulnerable to tighter U.S. monetary policy and the resulting stronger dollar, especially China’s heavily-indebted corporate sector. And European corporate bond yields this month hit the highest in two years.
Investors are voting with their feet. According to Bank of America Merrill Lynch, high grade bond funds have posted outflows for five weeks in a row, and high yield funds have posted outflows for 32 consecutive weeks.
“The credit cycle is past its peak, and credit tends to lead equities in signalling a maturing cycle,” wrote TS Lombard analysts in a note earlier this month. “The credit cycle is fast maturing.”
These are potentially worrying signs at this juncture in the economic and market cycle. The economic expansion is the second longest since World War Two, and Wall Street is only three months away from its longest bull run ever.
As the economic cycle matures, share gains are often achieved by higher debt leverage, which push credit spreads out. This eventually catches up with stocks as the economy grinds to a halt or even shrinks.
As the current U.S. expansion enters its tenth year, company debt is increasing faster than income. At the end of 2007, just as the economy was about to enter recession, non-financial corporate debt was $3.35 trillion, or 23 pct of GDP, according to the St. Louis Fed.
At the end of 2016 that had risen to $5.8 trillion, or 31 percent of GDP, both record highs. The nominal debt pile is now over $6 trillion.
With interest rates floored at zero for years after the 2008 crash, this is no surprise. After all, encouraging households and companies to borrow in order to spend and invest was a central plank of QE.
But leverage is now above long-term averages. At the end of last year, almost all U.S. sectors’ leverage ratios were above their 20-year average, the exception being industrials, according to Societe Generale.
“This is a classic late cycle phenomenon, where companies do things that are good for shareholders but not so good for bond holders,” said Matt King at Citi in London.
As the economic cycle edges closer to turning, executives are increasingly finding that the only way they can grow their business and maintain share price value is through stock buybacks and merger and acquisition activity.
Buybacks and M&A are generally funded by debt and cash. It puts a solid floor under the stock price, but weakens the company’s credit profile.
The tech sector is the exception currently proving the rule. Thanks to Apple, Microsoft, Amazon and others sitting on huge piles of cash, the sector has a negative leverage ratio, that is to say it is net cash positive.
— The opinions expressed here are those of the author, a columnist for Reuters —
Reporting by Jamie McGeever; Editing by Jan Harvey