Santoli: Bonds signal doom as stocks rise

Published Mon, Dec 7 201512:57 PM ESTUpdated Tue, Dec 8 20157:00 AM EST

The question garnering the most interest among investors right now is whether stocks are heedlessly failing to give credit its due. The credit markets, especially the riskier high yield sector, have weakened considerably this year — even during the past month, when the major stock indexes have managed to hustle back up toward their highs for the year. This disagreement among markets is generating plenty of alarm, consternation and rationalization as investors try to gauge the market's ability to withstand a Federal Reserve interest-rate boost and determine the prospects for stocks in 2016. The main high-yield debt indexes are sitting close to their lows of the year. And the interest-rate spread over Treasurys on these so-called junk bonds is near its high for the year, and indeed is close to its post-financial crisis high. This shows significant risk aversion by credit investors, as they sell bonds of financially strapped companies and demand higher yields to compensate for the hazard of holding them. Standard & Poor's Ratings Services reports that more than 20 percent of the outstanding high-yield bonds are now considered "distressed" based on their deeply discounted trading value implying substantial risk of default. The last time this ratio was higher was late 2009. Meantime, Financial Times reported last week that some $1 trillion worth of corporate debt has had credit rating downgrades this year. High-yield did rally nicely starting in late September, around the time stocks bottomed following the market correction. But since the first week of November, junk spreads have been on the rise, even as the Standard & Poor's 500 has managed to push above the 2,090 level — less than 2 percent from its all-time high. Read More Goldman's Fed rate-hike playbook The reason many observers are growing anxious over this divergence is that credit markets tend to lead, or at least confirm, moves higher and lower in stocks, and the corporate bond market tends to execute fewer head fakes than the stock indexes do. Morgan Stanley U.S. equity strategist Adam Parker, in his 2016 outlook report last week, noted that his enthusiasm for stocks next year was dampened after huddling with counterparts in the bond market. Parker has for some time been suggesting that this should be an unusually long economic expansion, perhaps stretching to the year 2020, and shows few worrisome excesses now. "On the other hand," he says, "our credit colleagues in particular are influencing our view that the credit metrics are starting to ring 'later cycle.' " As a result, he's forecasting the S & P 500 will be flattish, up less than 3 percent next year to 2175. Of course, this might not take into account an even more disappointing result, considering that the ugliness in high yield has the bearish crowd pointing out that the last time a loud warning from junk went unheeded was in 2007, before the mortgage crisis broke loose upon the capital markets. Scary as that might seem, there are plausible reasons that the freak-out in credit isn't an infallible augury of doom. Most obviously, the crash in oil prices and other commodities has spread carnage among energy and natural-resource companies, and their bonds are by far the weakest of any group. The chart below from Bank of America Merrill Lynch shows how much worse the surge in risk spreads looks when commodity companies debt is included. Source: Bank of America Merrill Lynch In this sense, the blowout in junk spreads is simply telling us what we already knew: Energy and metals prices have collapsed, leaving a huge amount of production underwater. That said, the nonenergy sectors don't exactly look all that healthy, either. But does this imply the debt markets are foretelling of an economic downturn? Goldman Sachs strategists last week argued that, in fact, the junk market "is sending a false recession signal." The firm recommends investors look to buy corporate debt at elevated yields, suggesting somewhat against the common wisdom, "Credit markets are likely to be no better at predicting recession than any other asset market." Read More Top strategist: Get ready for 'difficult' year Others will point out that the long period of strong credit markets leading into this year had allowed companies of almost every quality to refinance and extend their debt schedules. This means there is only a negligible volume of bonds coming due before the 2017-to-2020 period. That's comforting on its face, but the researchers at asset manager GMO LLC point out that corporate bond defaults in past cycles have tended to surge and peak a couple of years before these "maturity cliffs" were hit. One unanswered element of all this is the effect of market illiquidity near year end. Several other areas of wholesale markets — overnight bank financing and the lie — have shown stress in recent weeks. Banks, as they close their annual books and hew to strict risk standards, are of little help smoothing out the high-yield market as retail investors withdraw cash steadily. There's still another way to argue that the stock market isn't wholly ignoring an important distress signal from high-yield bonds: The advance in the equity indexes themselves has been disproportionately driven by the shares of a small number of big growth companies. And those winning companies are all self-financing businesses with fast-growing revenues and no need for the generosity of creditors. Meantime, energy , basic-materials and industrial stocks have been crushed this year, and small-cap stocks — usually more credit-dependent — have lagged bigger-cap benchmarks this year. So could it be that stock investors haven't been quite as clueless as worrywart credit-market types would have us believe? We might not have to wait long for an answer to that question, as we watch the capital markets metabolize a likely Fed rate hike and a new year with clean fund performance slates get underway.

Traders work on the floor of the New York Stock Exchange.

Getty Images

The question garnering the most interest among investors right now is whether stocks are heedlessly failing to give credit its due.

The credit markets, especially the riskier high yield sector, have weakened considerably this year — even during the past month, when the major stock indexes have managed to hustle back up toward their highs for the year.

This disagreement among markets is generating plenty of alarm, consternation and rationalization as investors try to gauge the market's ability to withstand a Federal Reserve interest-rate boost and determine the prospects for stocks in 2016.