We have been warning for a while that not only is the high-yield credit market sending a warning but that it is critical for equity investors to comprehend why this is such bad news. This week has seen exuberant equity markets start to catch down to high-yield's warning but today's surge in HY credit spreads to six month wides is a rude awakening. Between outflows, a huge wall of maturities (and no Fed liquidity), and corporate leverage, the reach-for-yield just became an up-in-quality scramble. HY spreads are over 70bps wider than cycle tights implying the S&P 500 should be around 1775. When the easy-money-funded buyback party ends, will you still be dancing?
High-yield protection is in huge demand - credit spreads surge to 6-month wides - implying a 1775 S&P 500.
As outflows continue to rise...
Outflows from high yield funds and ETFs amounted to $1.69bn this week following a notable outflow of $2.46bn last week and a $1.85bn outflow in the week prior to that. The last three weeks account for the largest outflows in HY this year. The outflows are likely a result of the selloff in high yield bonds in July, as flows typically follow return.
You were warned:
* * *
Between a sudden shift to a preference for "strong" balance sheet companies over "weak" balance sheet companies (the end of the dash for trash trade), and this rotation from high-yield to investment-grade, it is clear that investors are positioning defensively up-in-quality ending the constant reach-for-yield trade of the last 5 years.
Why should 'equity' investors care? The last few years' gains in stocks have been thanks massively to record amounts of buybacks (juicing EPS and also providing a non-economic bid to the market no matter what happens). This financial engineering - for even the worst of the worst credit - has been enabled by massive inflows into high-yield and leveraged loan funds, lowering funding costs and allowing CFOs to destroy/releverage their firms all in the goal of raising the share price.
Simply put - equity prices cannot rally for long without the support of high-yield credit markets - never have, never will - as they are both 'arbitrageable' bets on the same capital structure. There can be a divergence at the end of a cycle as managers get over their skis with leverage and the high yield credit market decides it has had enough risk-taking... but it only ends with equity and credit weakening together. That is the credit cycle... it cycles.