October 23, 2018
Because of the below-normal volatility in stocks over the past five years, save for sharp corrections that were few and far between, the recent sell-off in the S&P 500 from 2940 to 2710 has generated the usual worried calls from clients wondering if “the top is in.” My answer is that it would be very unusual for the stock market to weaken further in a good earnings environment in the seasonally strong time of the year.
As to why the S&P 500 dropped so fast, there are several factors I discussed here previously, but suffice to say such a percentage move in the month of October 20 years ago would have been viewed as normal.
When the stock market gives us mixed signals, it is usually a good idea to look at other asset classes to get a better read on the situation. The bond market is much more “rational,” for lack of a better word, and much more sensitive to the performance of the U.S. economy, while stocks have historically been more erratic in such situations. One part of the bond market that has a heavy correlation with the stock market is junk bonds, or anything rated BB or lower by S&P. If junk bonds are doing well and stocks are under pressure, that’s a good indication that the weakness in stocks is transitory.
Years ago, a veteran bond trader explained the junk bond market this way: “It reads like a bond but trades like a stock,” meaning that lower-rated bonds have higher volatility compared to Treasuries.
While Treasuries have been under pressure due to the Federal Reserve quantitative tightening cycle, we have had a flattening yield curve, which in the past month or so has steepened marginally, but it’s not the absolute level of yield that matters in the bond market but the relative yield. In other words, the spread.
Narrowing spreads between junk bonds and Treasuries, even if Treasury yields are rising, is considered a sign of a strong economy. A strong economy tends to produce a strong stock market, as has been evidenced by the strong earnings growth in the first and second quarters, which is expected to continue in the third quarter. The stock market does not have to follow strong earnings performance by the S&P 500 companies immediately, but over time it typically follows it, despite any delays.
So, what are junk bonds telling us now?
When it comes to junk bond indexes, BB indexes show us the highest-quality junk, where CCC or lower indexes show us the performance of the junkiest of junk bonds. BB spreads have stopped going down and are more or less going sideways since narrowing by more than half since early 2016. At 2.34% the BB spread index to Treasuries is considered low – an indicator of a strong economy.
The junkiest of junk, CCC or lower-rated bonds, actually show a narrowing of spreads in 2018. For most of 2017, CCC bonds had spreads to Treasurys in the 8% to 9% range. At 7.05%, junkier junk bonds show a strong economy that has gotten stronger. In 2018, we have been as low as 6.59% in late September. Despite a marginal widening, CCC spreads around 7% are considered a sign of a strong economy.
The narrowing of credit spreads in riskier bonds is a direct consequence of the fiscal stimulus introduced by the Trump administration in the form of a tax cut at the end of 2017. While philosophically such fiscal stimulus should have come if the economy were to be weaker (like during a recession) in order to help it recover, such longer-term considerations do not appear to be the priority of the present administration.
What are Emerging Markets’ Bonds Saying?
Unlike the U.S., spreads are widening in high-yield bonds in emerging markets. In the aggregate, it is not huge, as it comes from an extremely depressed level and it would be considered normal in a Federal Reserve tightening cycle and a general outflow of capital from emerging market stocks and bonds.
The situation is significantly more gruesome in some individual cases where local “risk-free” government bond markets are under significant pressure, causing significant pressure in the whole financial system, not just for junk borrowers. Turkey’s 10-year government bond closed on Friday with a yield of 18%.
Turkey also has an inverted yield curve, where the policy rate is set at 24% and the Turkish 2-year note closed at 24.46%. An inverted yield curve is a sign of trouble and indication that many market participants are worried that Turkey may default on its obligations.
As a general observation, signs of stress in the U.S. bond market are low and decreasing while signs of stress in emerging market bonds are rising (from a low base) but materially so in some cases, namely in Argentina and Turkey. I think this dynamic will persist in 2019, when more bad news from emerging markets should be forthcoming, courtesy of their rampant dollar borrowing in the previous decade based on the erroneous assumption that U.S. interest rates would stay low and not materially rise.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.