Investors have realized that interest rates aren’t the only risk in markets. Now that the genie is out of the bottle, the future looks increasingly perilous for stocks and junk-rated corporate credit, with hazards coming from two directions at once.
In some ways, what’s shocking is how long it took to get here. As recently as last week, option-adjusted spreads on US high-yield bonds were just 389 basis points above Treasuries. Not only is that non-recessionary, but it’s well below the average for the 10 years before the Covid-19 pandemic. For their part, equity risk premiums — in some ways the other side of the same coin — fell recently to levels so stingy that Morgan Stanley strategists dubbed them the “death zone.” All things considered, risk markets looked somewhat indifferent to the growing earnings risk and downturn odds.
That has changed drastically since the close of trading on March 8, when investors started to worry about developing crises in the banking sector. The run on Silicon Valley Bank jolted the market into the realization that the Federal Reserve’s breakneck monetary policy tightening isn’t likely to pass without destabilizing consequences. Although the broad stock market recovered a bit from its early week lows, the scars are plainly visible in spreads and equity premiums.
That doesn’t mean that high-yield spreads and equity risk premiums are pricing in a recession, of course, but we have left the realm of fantasyland. US high-yield spreads have jumped 85 basis points since March 8 to 4.85 percentage points as of the time of writing, which puts them right around their pre-pandemic norms. If corporate bond traders tend not to price a recession until it’s basically on their doorstep, they are at least acknowledging that the threat is somewhere in the neighborhood.
Meanwhile, the equity risk premium — measured here as the difference between forward S&P 500 Index earnings yields and 10-year Treasury yields — has soared 68 basis points to 2.19 percentage points since the SVB developments.
The question now is whether that was simply part of a knee-jerk reaction to the banking turmoil — which could ultimately reverse itself if the bank crisis abates — or whether investor psychology has changed in an enduring way. My best guess is that a lot of this will stick.
All things considered, it’s not entirely surprising that some investors have stayed invested in high-yield bonds as long as they have. In a note this week, Oxford Economics associate director Alessandro Theiss attributed the erstwhile low spreads to relatively healthy corporate balance sheets and investors’ search for yield compensation against high inflation. With year-over-year inflation peaking around 9%, it has become incredibly tempting for investors to slide up the credit-risk ladder.
And among high-yield issuers tracked by Bloomberg Intelligence, interest coverage ratios — the ratio of operating profit to interest expense — remain comfortably above their 10-year average in most sectors.
Of course, that can change quickly if a recession materializes, as Bloomberg Economics predicts it will. The median forecast in a Bloomberg survey of economists puts recession odds in the next 12 months at 60%. Here’s Oxford Economics, which is also in the recession camp:
A weaker economic performance will cause deterioration in corporate earnings and an eventual rise in defaults. Second, global credit standards have sharply tightened recently – the latest reading of our in-house indicator is the worst since 2009 – flashing a key warning sign for the corporate outlook. Tighter lending standards will weigh particularly heavily on the profitability of lower-rated issuers, and they tend to lead to a rise in bankruptcies.
Noel Hebert, Bloomberg Intelligence’s chief US credit strategist, wrote Thursday that credit metrics are already “showing signs of inflection.”
Leverage, margin and interest coverage are all weaker, while free cash-to-debt has edged higher. We are standing by our view of continued erosion through 2023 amid weaker economic and operational trends.
Then, of course, there’s the stock market, which has been its own riddle. In a note dated March 13, Morgan Stanley equity strategist Michael Wilson — one of the cycle’s best-known bears — reiterated his long-held view that equity risk premiums would shoot higher.
Our very much out of consensus view on earnings is now likely to get properly priced via the Equity Risk Premium which has remained well below fair value. If such a period of adjustment has begun, one should expect at least a 200bps rise in the ERP from the recent lows of 150bps.
According to Wilson and his team, that 350 basis-point premium would put the forward price-earnings ratio for the S&P 500 at around 13 to 15, depending on Treasury yields, of course, compared with about 18 now.
It’s important, of course, to end with the usual caveat: The US economy — including both household and corporate balance sheets — is starting from a position of notable strength, and the last month’s bout of volatility needn’t be interpreted as a sign that “the recession is here.”
But either way, it’s getting harder to tell an optimistic story about junk bonds and stocks. The days of lackadaisical equity and credit risk premiums are behind us. If the economy muddles along for six more months, that may well mean that Treasury yields will rise again, pressuring asset prices. If it collapses, spreads will jump higher. The 2023 banking sector panic may not have a significant economic impact in the end, but there will likely be a longer-term impact from all the frayed nerves. That means investors will have to fight risks coming from two fronts going forward.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company's Miami bureau chief. He is a CFA charterholder.