Thanks in large part to a circuit-breaking selloff in China, stocks are already digging a hole at the start of the new year. Savvy traders know to avoid making big decisions based on a day or two of equity market histrionics, lest they look like chickens with their heads chopped off rather than skilled prognosticators. They rely on more dependable barometers to determine the longer-term direction, and what they see right now could be a big cause for concern.
One of the best current indicators is dollar-denominated investment-grade debt, which has been tracking U.S. stocks much more closely than high-yield bonds. High-grade bonds remained fairly steady throughout 2015's market roller coaster, even as stocks bounced around in a rather fruitless attempt to find direction and riskier corporate debt suffered some of its biggest declines on record.
This makes sense. U.S. top-rated corporate bonds have been "the only game in town,'' providing about 75 percent of global corporate yield income, up from 50 percent in 2011, Bank of America credit strategists led by Hans Mikkelsen wrote in a Dec. 29 report. They're an attractive alternative for investors who aren't enamored of the prospect of negative yields on European government debt, junk bonds that are in a world of pain and American stocks that seem aimless and jumpy.
Here's where the caution light comes on: Investors seem to be growing less enthusiastic about this top-tier debt. Investment-grade bond funds experienced an exodus of investor money in the final month of 2015, suffering their biggest weekly withdrawal in 17 weeks and leading a $25 billion three-week withdrawal from global bond funds, Bank of America research shows. The debt lost 0.7 percent in December when stripping out gains from benchmark Treasuries, its biggest such decline for the year.
These companies are borrowing money to acquire rivals and buy back shares to increase their stock prices. This has ended any deleveraging that took place in the wake of the worst financial crisis since the Great Depression, making these companies less creditworthy.
Any further weakness in high-grade credit bodes poorly for North American equities. "The buyback piggy bank would be closed, taking away what has arguably been the biggest driver of many U.S. stocks,'' wrote Brean Capital's Peter Tchir in a report dated Sunday. Also, he notes, any lasting decline in investment-grade bonds would signal growing concern about the world's biggest economy.
Stocks don't need any more momentum for the rout that began on the first trading day of 2016. In addition to China's issues, traders are citing mounting tensions between Iran and Saudi Arabia. China's situation isn't new or unknown, and while the antagonism between the two Middle Eastern oil powers is real and mounting, both nations have incentives to de-escalate the conflict.
These factors could be the equivalent of fireworks, intense flashes in the market that fade quickly. Investors should keep a close eye on less-flashy U.S. investment-grade bonds. If this market keeps deteriorating, that'll give this latest equity plunge some real steam.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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