Credit Markets Not Pricing Economic Risks Correctly
The continued saga over the central bank printing press is creating a degree of moral hazard never seen before. In the S&P 500, there are about 10% of companies that do not earn enough to cover their interest payments and about 150 that are not investment grade. These are being kept alive by cheap money—and this was before COVID. The numbers are obviously worse today, though implied support from the central bank makes risk of owning weak companies very distorted. High yield spreads should probably be several hundred basis points wider than they are today without the implied support. But don’t worry, just buy what the Fed says they will buy and don’t fight the Fed. Central bank policies are creating a massive asset bubble, but there is no telling when it breaks. When they think about thinking about pulling back, look out below.
Credit markets are said to be a leading indicator. This is another part of our PRO EYEs series of indicators that is currently flashing a cautionary message. But as history shows, credit spreads can stay narrow for extended periods of time before widening. A wider spread is telling markets risks are increasing. In our first chart (lower) shows the yield to worst (maturity). We can see that all levels Government, Corporate Investment Grade and High Yield (below investment grade) are all at or near record low levels. The middle chart (inverted) is the spread between investment grade and high yield. This is the difference between good quality companies and weak ones that are mostly just hanging on largely because of cheap money. If they had to pay historical risk rates, many would not make it. These are the zombies. Many should go bankrupt. You can see the high correlation between credit spreads and equity markets. What is key here are divergences. When equities make a new high and credit spreads do not narrow. We have not seen this yet, but we are looking very closely now as US equities are making new highs.
S&P 500 versus Corporate Bond Yields
Another leading indicator is the high yield spread relative to “safe” government debt. This is another metric in our model as a leading indicator. This is often where the divergences tend to show up first. The bottom chart is what is called a Z-Score of the high yield spread. A Z-Score is a statistical measure of how far the underlying has deviated from the mean and gives us a precise apples to apples measurement for divergences. We now see new highs in the S&P 500, but credit spreads for high yields are lagging. Time will tell if this is a meaningful signal—we think it has to be. It likely depends on the Fed and implied support for markets (moral hazard). Without it, we think the S&P 500 would be about 30% lower.
High Yield Spreads versus S&P 500
The Fed meets this week and we doubt they say anything negative at all. But as we noted last week, bond supply is massive and the Fed is not buying enough. Let’s watch credit markets and the central bank support for credit markets. Sadly, they may need to do even more to keep the party going.
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