06.07.2023 Liquidity – the availability of funds to borrow, spend and invest – is the lifeblood of the financial markets. Markets rise when liquidity flows and fall when credit dries up. The ongoing combination of the highest short-term rates since 2007 and stricter lending standards among our nation’s banks is expected to deliver a one-two punch to risk takers. But, to date, it hasn’t happened. How will investors know when that shoe is about to drop?
The yield premium junk bond holders require has reacted to the banks’ collective caution. The yield differential between 10-year, BBB-rated corporate bonds and their A-rated counterparts paints a similarly sanguine picture. Bond holders seem unworried about the prospect of downgrades, even though the next stop below BBB is junk. Perhaps they’re simply satisfied with the nominal yield at its highest level in nearly 14 years, with BBB bond yields at 5.5% – more than three and a half percentage points higher than they were at the beginning of 2021.
History has shown that the equity market takes its cue from liquidity, as measured by both nominal yields and credit spreads. The S&P 500’s forward price/earnings ratio moves in tandem with BBB bond yields, a rough proxy of the cost of capital for most constituent companies. The period after the financial crisis, when the Federal Reserve held interest rates artificially low and embarked on quantitative easing, was the exception.
Many investors are now waiting for credit conditions to deteriorate. Banks’ unwillingness to realize losses on their loan books has promoted the proliferation of zombie companies, those firms whose cash flows don’t cover their debt service. We estimate that about one-quarter of the Russell 2000 companies, representing nearly one million jobs, are currently not generating enough cash flow to cover their debt service payments. Unless interest rates suddenly turn lower, these companies will either default or face debt restructuring and the banks will have to write down the loans.
Notwithstanding that daunting backdrop, credit conditions, as gauged by the public debt markets, remain robust. The credit yield premium on 10-year, BBB bonds is currently trading below its 200-day moving average, suggesting risk conditions remain in place. This gauge has been a good early warning indicator of equity market trouble. The indicator “broke down” in early February 2022, early 2020, and most notably in Q4/07 – a full year before the equity market maelstrom of 2008.
Bottom Line: Like most investors, we’re on the lookout for signs of credit deterioration coupled with a recession as firms grapple with higher financing costs and narrower profit margins. Business sentiment, like business investment, is moribund. However, equity markets remain stable. We believe bond market credit spreads offer the best early warning indicator of trouble. For now, the credit markets are signaling “stay the course.”