The warnings from credit watchers have been coming for months: A looming wave of corporate defaults is going to shatter the calm in equity markets. And still, US stocks have powered to highs last seen in August.
(Bloomberg) — The warnings from credit watchers have been coming for months: A looming wave of corporate defaults is going to shatter the calm in equity markets. And still, US stocks have powered to highs last seen in August.
Credit Cassandras point to the escalating threats. Repeat bankruptcies are climbing at the fastest pace since the financial crisis, borrowing costs keep rising and bank lending standards are tightening. Spreads on the riskiest company debt will have to widen as the economy slows, according to many Wall Street veterans. That would jolt equity markets turning a blind eye to dangerous credit burdens, they say. A strong link between rising junk bond yields and volatile stock markets has been evident for years.
“Markets appear unduly optimistic about the outlook,” says Matthew Forester, chief investment officer of Lockwood Advisors at BNY Mellon Pershing. “We don’t believe current credit spreads, especially in lower-grade credits, are compensating for cyclical, political and geopolitical risks. High-yield spreads need to move materially higher.”
For now, both stocks and credit appear unflappable in the face of stress that’s nevertheless caught the attention of Jay Powell, Federal Reserve chair. Citigroup Inc. strategists wrote this week about a new bullishness in the S&P 500, and a political deal on the US debt ceiling may bolster that. Average speculative-grade corporate spreads — the yield these bonds offer above investment-grade equivalents — are less than 500 basis points. That’s a long way from pricing in recession or a credit crunch.
But if spreads start to widen under a deluge of corporate failures, that could be a tipping point for stocks, based on the historical correlation between equity volatility and high-yield spreads. Shares of smaller and heavily indebted companies would bear the brunt.
Bigger spreads look increasingly likely. In the event of a US recession in the next year — the odds of which are being put at 65% — they could rise to at least 1,000 basis points in the high-yield bond market, according to Marty Fridson of Lehmann Livian Fridson Advisors, who argues that they should already be 750 basis points to reflect tightening credit. Models created by Societe Generale SA also suggest this would feed into far more volatile stock prices.
Credit fears are at least prompting greater discernment among equity investors, even as stock indexes advance this quarter on both sides of the Atlantic. Fund managers are paying closer attention to company fundamentals, favoring those with robust balance sheets. The shakier a company’s finances, the worse its shares are doing, data compiled by Bloomberg show.
This disparity between the haves and have nots will become starker as the economy slows, says Andrew Lapthorne, SocGen’s head of quantitative research. “Ultimately the balance sheet story becomes most important when profits are declining during a recession and we’re not there yet,” he says. “There are the concluding phases — recession — when markets sell off or react to something and the weakest balance sheet stocks get crushed.”
A basket of stocks with the healthiest balance sheets is up 14.5% this year; those with the highest debt rose just 1.1%. That’s the second-biggest outperformance since 2007, according to Goldman Sachs Group Inc. data.
Speculative growth stocks that proliferated during the easy-money era will be among the most vulnerable to this safety-first shift. Unprofitable tech firms — whose shares soared more than 300% in the two years up to their February 2021 peak, according to a Goldman Sachs index — look exposed.
Smaller companies will be doubly nervous. In the second quarter of 2023, analysts expect the Russell 2000 small-cap index to post a 9.7% drop in revenue, compared with a 0.4% loss for the big beasts of the S&P 500. The current gap between sales estimates for S&P 500 businesses and their Russell 2000 counterparts is the widest in seven years.
While unprofitable tech startups may be staring down the barrel, their bigger, profitable peers are in a happier place. The latest Bank of America Corp. survey shows investors boosting allocation to these companies at a rapid clip. That reflects confidence that these giants with rock-solid balance sheets and lots of cash will weather recession better than those saddled with debt.
“Slowing economic growth calls for a focus on quality companies — those defined by high profit margins, low debt levels, high free cash flow yields and return on capital,” says Helen Jewell, EMEA deputy CIO of BlackRock Fundamental Equities. “It’s these underlying fundamentals that have been the key determinants of stock returns historically.”
–With assistance from Michael Msika and Sam Potter.
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