One of the biggest disconnects in the market in recent years has been the unprecedented divergence, shown below, between stocks and (initially) junk bonds, although the weakness is spreading across all fixed income verticals.
That all changed last week when the very same mutual and hedge fund gating shockers that unleashed the 2007 crisis made a very unwelcome appearance, leading to a very unpleasant episode of deja vu even among equity investors who until this point were happy to keep their heads planted firmly in the sand.
As a result, even Goldman has finally been forced to observe over the weekend that "despite the decline in stock valuations, US equities have performed far better than credit, causing investors to ask us, “What does the credit market see that the equity market does not?” Goldman also adds that "high yield credit spreads have widened dramatically since June and are currently in territory typical of recessionary environments." Which makes sense: after all at least half the US economy, that which relies on industrial production and manufacturing is in a recession:
And while it won't come as any surprise to our readers, Goldman also observes that the HYG ETF has fallen to its lowest level since 2009 (and is even lower in the premarket). In contrast, the S&P 500 is just 6% below its all time high of 2131 reached in May of this year.
How is this possible? Here are Goldman's five proposed answers:
1. Credit is sending another false recession signal. While credit spreads at current levels gave advance warning of recession in 1990 and 2001, our credit strategists note that spreads in 2008 didn’t reach current levels until the recession, and in 2011 were a false signal. Most economic data suggest current recession risk is low and we expect credit spreads will tighten in 2016. See Global Credit Outlook 2016.
Unless of course, credit is sending an accurate recession signal, and it is Goldman's equity strategists who are unwilling to admit that their 2100 price target for 2016 is woefully inaccurate in a year when the Fed is set to soak up trillions in excess liquidity.
2. Liquidity is one reason for the sell-off in credit that is not an issue for stocks. Liquidity in the corporate credit market has been a widespread concern during the past two years and grabbed headlines again today. In contrast, liquidity in the equity market remains robust, with trading turnover higher YTD than during the first 11 months of 2014.
Liquidity in equity markets remains robust? You mean like on August 24?
3. The narrow mega-cap equity market leadership has exaggerated the difference between YTD performance of equity and credit. The top few contributors to S&P 500 YTD return have pushed our breadth index to nearly the lowest level in its 30-year history. While the S&P 500 total return YTD is 0%, the median stock has returned -2%, and the HY index has returned -6%.
Oh so the equity market isn't really so "sanguine" if one excludes just the top 4 names which have accounted for all the S&P's gains... well, there are no longer any gains but you get the idea.
4. The HY market’s large weight in Energy and commodity-exposed industries is a major driver of weak credit returns. At the start of the year, Energy and Materials firms accounted for 12% of S&P 500 market cap but roughly 25% of the HY credit market, as measured by the BAML High Yield Master II Index. If the S&P 500 shared the same sector composition as the HY index, it would have returned -3% YTD rather than its actual 0%.
Actually this is total bull: as we have shown previously [9], while this statement may have been valid a year ago, the junk bond rout has long since spread to every sector, even those that were supposedly expected to benefit from low oil prices.
[10]
Finally:
5. Credit markets are reacting to a real deterioration in corporate balance sheets that the equity market has yet to digest. Ex-Financials, the median S&P 500 firm’s net debt/EBITDA is at the highest level in more than a decade, rising from 0.8 in 2010 to 1.0 at the start of 2015 to 1.3 today.
So after building up a strawman in 4 points why credit is wrong, Goldman finally admits that it is credit that is always ahead of the game and stocks either get a central bank bailout or are whacked on the head with the usual several month delay in which they take the elevator down and after the fact complain how "nobody could have possibly foreseen this."
Needless to say, with every incremental hedge fund liquidation and gating, the elevator ride gets closer.
