There has sure been a lot of noise in the financial media the last couple days. From fears of China, to fears of a HY default spiral, to fears of a Fed hike, to fears of the Fed not hiking, people seem to be manufacturing reasons across the board.
The real reason is much simpler and none of the above.
The reason behind much of the price action year to date is the widening in credit spreads. The chart below illustrates the relationship between credit spreads and equity returns throughout the cycle. And it makes sense – more expensive credit is a tightening of financial conditions, which slows expenditures. As the chart shows, spread widening has been a drag on equity returns for more than 12 months now:
Now, the knee jerk reaction here may be: crap! Spreads are now at the 2011/2012 wides! Risk off!! Sellllll!!!!
Well, maybe that’s not everyone’s reaction but it seemed like it yesterday. But let’s dig a little deeper.
Credit spreads are obviously composed of two legs, corporate bond yields – treasury bond yields.
Treasury yields have been falling – with most of the move in the inflation expectations component due to oil. Quite arguably, in some parts of the curve it’s getting a bit overdone. The chart below from Barclays illustrates that even in the 5y5y inflation forwards, we are back down to 1Q levels:
At the same time, corporate bond yields not falling. Why? Well, issuance is probably a pretty strong reason. After all, pretty much the entire world is expecting the first Fed hike this year, with consensus expectations most of the year set for September. As a result, corporations have scrambled to front load their issuance. Goldman had a couple good charts on that. Not only has total issuance hit new highs:
But the duration of issuance has as well, as corporations have extended the duration of their borrowing:
By default, with corporate bond yields stable and treasury yields lower, that means the spread is widening. And with the issuance pattern and the front end of the US curve pinned, that means the widening pressure is strongest at the long end.
So does that mean it’s time to liquidate? Well, that depends on how spreads move from here.
Let’s take a look at spreads historically. In prior recessions, wider spreads unsurprisingly got wider, as bond buyers became increasingly concerned that economic weakness would translate to higher default rates. Is that the case this time?
Here’s a chart of spreads (red, RHS) vs a proxy for growth, the ISM composite survey. (blue, LHS, inverted) See anything that stands out?
A model that regresses macro data vs spreads suggests that spreads have overshot by the largest extent since 2012 and potentially 2009:
In addition, if you think that corporations have been front loading their issuance ahead of the Sept FOMC, that suggests the possibility that issuance is likely to slow regardless of whether the Fed hikes in Sept or not. In addition, oil will bottom (at some point, right?) which should support inflation breakevens and help treasury yields to rise. This all points to the likelihood of spread tightening in 4Q. And not just in 4Q… given how wide spreads are given the economic backdrop, we are likely to see sequential quarters of it.
Furthermore, many positioning indicators suggest that we are at or near capitulation levels. Here are two.
First, a Barclay’s chart of money market fund flows:
And the BAML survey cash indicator:
In addition, note that European equities are now cheap vs UK, US, Japan. Furthermore, relative prices vs the US is at most attractive level since January. (The chart below is the ratio of the S&P vs the Eurostoxx 50)
It’s hard to get the timing exactly right, obviously, but I do think that we are getting set up for a strong risk-on move into 4Q and 2016 here, likely lead by Europe.