New York: Credit markets foretold the sell-off in US equities. Should they also prove prescient in calling its extent, stock bulls have more to worry about.
In the three times when the extra yield bond investors demand over Treasuries has climbed as much as it has since May, the Standard & Poor’s 500 Index has lost an average of 18 per cent, according to data compiled by Bloomberg since 1996 that excludes recession years. At its lowest level last week, the benchmark gauge for American equities was down 12 per cent from its May peak.
Although the relationship doesn’t always hold, equity investors have been glued to the credit market after its signals foreshadowed the worst stretch for American stocks since the turmoil in 2011 when the US lost its AAA rating at S&P. The widening in bond spreads that began as equities sat at records is now viewed as something that should have been heeded, a sign that a surging dollar and turmoil in China would one day take a toll in the US.
“The credit widening has been a fear signal. The market took it and finally began to sell off,” said Brent Schutte, senior investment strategist at BMO Global Asset Management in Chicago, which manages $250 billion (Dh918.25 billion). “There are nervous investors out there who have ridden the market for five years and have been sceptical. Now that they’re seeing this, they may be selling.”
Credit spreads continued to widen in the run-up to this month’s stock rout, with the extra yield over Treasuries climbing 12 basis points to 170 since the start of August. Equity investors gave in on August 18, pushing the S&P 500 into a descent that lopped more than $2 trillion of its value at the lowest level.
Now the bull market that at one point lifted stock prices more than 200 per cent since 2009 is facing one of its biggest challenges to date. Into concerns about stagnant profit growth and stretched valuations has crashed China, pulling the US market into its first 10 per cent correction in almost four years.
“You have slow growth in the global economy, and you’ve got real issues in China and the commodity markets,” said Martin Sass, founder of New York-based M.D. Sass, which oversees $7.5 billion. “It’s a caution sign that the equity market had ignored the widening spreads. And then when they woke up to that, investors got very emotional.”
Yield premiums on investment-grade debt have widened by 32 basis points over the past three months, according to Bank of America Merrill Lynch index data. Since 1996, there have been five occasions when credit spreads showed similar expansions. Two of them preceded recessions in 2001 and 2007 when stocks went on to drop 50 per cent or more.
In the other three instances, the S&P 500 fell at least 16 per cent while the economy continued to grow. The latest was in August 2011, when the S&P 500 was mired in a 19 per cent retreat that almost ended the bull market.
Assuming the US economy will be able to avoid a recession this year, as predicted by economists surveyed by Bloomberg, and stocks fall by the average magnitude to reflect similar credit stress in the past, the S&P 500 would hit 1,742, a 18 per cent decline from its all-time high reached in May. That level, last seen in February 2014, represents a 12 per cent drop from its Friday close.
This month’s sell-off has come as reports show the US economy expanding. Gross domestic product rose at a 3.7 per cent annualised rate in the second quarter, more than previously forecast, the Commerce Department said Thursday. Data last week also showed consumer spending and personal income climbed and new home sales rebounded.
Rather than focusing on the last two weeks or trying to pick the bottom in equities, investors should prepare themselves to buy, according to James Tierney, chief investment officer of the concentrated US growth unit at AllianceBernstein Holding LP in New York.
“People overreact to things,” said Tierney, whose firm oversees $486 billion. “That’s when you start thinking, as an equity investor, how do I get re-engaged, how do I put more money to work as opposed to should I be pulling my money out of the market?”
After the six-day plunge that was the steepest in four years, US stocks rebounded Wednesday and Thursday, with the S&P 500 staging the biggest two-day gain since March 2009.
It took about a year for stocks to heed the warning signal from credit markets. In the 12 months through July when spreads expanded, the S&P 500 rallied 9 per cent, shrugging off Greece’s impasse with creditors and the plunge in oil prices. Even after the retreat this month, the index trades at 17.6 times earnings, about 9 per cent higher than its five-year average.
“I don’t think credit markets, equity markets and the global growth outlook are all in sync right now,” said Steve Wruble, chief investment officer who oversees about $1.2 billion at Portland, Oregon-based RiskX Investments. “You could get a full-blown correction and return to more reasonable valuations.”
