The Daily Prophet: Stock Bulls Can't Ignore the Junk Bond Slump
Speculative-grade corporate bonds have been a very good leading indicator for markets in recent years. The evidence backing up that assertion is more than just anecdotal. A recent paper by Omri Even-Tov of the University of California at Berkeley concluded that high-yield bonds tend to predict the stock performance of a slew of issuers, especially on the heels of earnings reports.
So that’s why equity investors should be very concerned about this current slump in junk bonds, which has been more severe than the hit stocks have taken in response to rising concern over North Korea and its nuclear capabilities. The iShares iBoxx High Yield Corporate Bond ETF is down 1.38 percent from its recent highs in late July, while the SPDR Bloomberg Barclays High-Yield Bond ETF is down 1.28 percent. This may be more than normal market gyrations. Morgan Stanley warned a correction may be under way, adding its voice to a growing chorus of skepticism surrounding debt valuations, according to Bloomberg News’s Charles T. Clark and Rachel Evans. Junk-bond investors now receive an average of about 3.7 percentage points more yield than Treasuries, up 0.16 percentage point since Friday and heading toward the biggest weekly increase since April, according to Bloomberg Barclays index data. However, that’s still well below the average for the last five years of 4.7 percentage points.
Remember credit-default swaps, the derivatives that everyone thought had special insights during the financial crisis? Not to be an alarmist, but the cost of protecting high-yield bonds against default in the credit-default swap market has climbed to the highest since mid-July. “This softness has a good chance of turning into a legitimate correction,” Morgan Stanley strategists led by Adam Richmond wrote in a research note. “We think complacency is too elevated.”
IT’S HARD TO PRICE ARMAGEDDON
What is surprising about the back-and-forth between the U.S. and North Korea over potential nuclear strikes is that financial markets have remained relatively calm. Yes, there has been some rotation of out of equities and into safe assets such as Treasuries and the Swiss franc, but not to the extent many would probably expect. The reason, according to some observers, is largely because in the worst-case scenario it’s impossible to guess the appropriate price for such things as financial assets, according to Bloomberg News’s Chris Anstey. That’s a point made by Mark Mobius, the Templeton Emerging Markets Group executive chairman and apostle for emerging-market investing. He said in a May interview about the prospect of a North Korean nuclear conflict: "There’s nothing you can do about it -- if something breaks out, we’re all finished anyway.” Asian bond investors are taking the latest geopolitical tension in stride as more companies line up to sell junk-rated dollar-denominated notes this week, according to Bloomberg News’s David Yong and Carrie Hong. Indonesian oil explorer PT Medco Energi Internasional is in the market with five-year bonds to help refinance existing debt, according to people familiar with the offering. Developer Greenland Holding Group Co. and China Huiyuan Juice Group Ltd. are both selling three-year notes. “The pipeline remains as strong as ever,” said Gordon Ip, head of fixed income at Value Partners Hong Kong Ltd.
CUE THE BOND BUBBLE WARNINGS
One of the biggest beneficiaries of the current demand for safe assets is U.S. Treasuries. The yield on the benchmark 10-year note touched 2.20 percent Thursday, its lowest level since June. That should only spark a renewed debate over whether the bond market is a bubble about to burst. After, at the start of the year most economists expected the yield to be closer to 3 percent by now and headed even higher. Bloomberg Intelligence rates strategist Ira Jersey notes in a report that yields may not be as out of whack as many believe. A simple model using data going back to 1947 shows that the 10-year Treasury yield today is quite close to what would be expected. The model uses real gross domestic product, the consumer price index, policy rates, and the share of the Treasury market owned by the Federal Reserve. Jersey and his team ran five scenarios using their model and found that if the performance of the economy plays out as forecast, then yields would climb slightly more than 1 percentage point by the end of next year. However, if growth and inflation continue to undershoot estimates, yields would be unchanged. Interestingly, the model suggests that an even better case where GDP expanded 4 percent and the inflation rate surged to 3 percent, yields would rise some 20 basis points.
WHATEVER HAPPENED TO DELEVERAGING?
Household debt outstanding -- everything from mortgages to credit cards to car loans -- reached $12.7 trillion in the first quarter, surpassing the previous peak in 2008 before the effects of the housing market collapse took its toll, recent Federal Reserve Bank of New York data show. While rising debt isn’t inherently bad or dangerous, what’s concerning here is that people are borrowing more not necessarily because they’re confident about their financial prospects. They’re doing it for necessities like education or transportation and, in many cases, just to get by, according to Bloomberg News’s Vince Golle. Household net worth stands at a record $94.8 trillion, thanks to rebounding home values and soaring stock portfolios. But that increase has primarily benefited the nation’s wealthiest, said Lance Roberts, chief investment strategist at Clarity Financial LLC in Houston and editor of the Real Investment Advice newsletter. “When you look at net worth, it’s heavily skewed by the top 10 percent,” Roberts said. “The average family of four is living paycheck to paycheck.” For most Americans, whose median household income, adjusted for inflation, is lower than it was at its peak in 1999, borrowing has been the answer to maintaining their standard of living. The increase in debt helps explain why the economy’s main source of fuel is providing less of boost than in the past.
… AND MAY ALSO HELP EXPLAIN RETAIL INDUSTRY WOES
Lots of people like to talk these days about how the retail industry is undergoing a structural shift due to changes in how consumers like to shop. But what if the struggles that retailers are grappling with have more to do with the jump in debt highlighted above? After all, retail sales have underperformed for some time now. Shares of retailers slumped again Thursday amid a fresh round of sales declines at Macy’s Inc. and Kohl’s Corp. that is renewing concerns that the department-store industry can’t pull out of a crippling slump, according to Bloomberg News’s Lindsey Rupp. Shares of both retailers declined after the quarterly results failed to assure investors that a comeback was taking hold. Same-store sales -- a key measure -- dropped 2.5 percent at Macy’s and 0.4 percent at Kohl’s. Dillard’s Inc., a department-store chain operating in 29 states, sank as much as 16 percent to $61.50 after posting a surprise loss in its second quarter. CEO Bill Dillard blamed the result on “significant markdowns” and a pileup of merchandise. Its inventory rose 2 percent by the end of the period.
Have economists given up on forecasting inflation? It would seem that’s the case ahead of Friday’s important Consumer Price Index report from the Labor Department. The median estimate of economists surveyed by Bloomberg is for core consumer prices to rise 0.2 percent in July -- the same as they have forecast each month going back to October 2015. If they are right, it would end a four-month string of below-forecast readings in the so-called core index, the weakest stretch since 2010. Most economists are counting on a depreciating dollar, rising import prices and a tight job market to generate stronger price pressures across the economy, according to Bloomberg News’s Shobhana Chandra and Rich Miller. Federal Reserve policy makers seem divided over the inflation outlook. Some blame the recent run of low figures on transitory factors -- cheap airfares being the latest culprit cited -- while others aren’t so sure. The resolution of that debate will go a long way toward determining whether the central bank presses ahead with its plan for one more interest-rate increase this year.
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