My nearly 25 years of trading HY has taught me that the sector is a good leading indicator for the equity market and the economy. I believe that, in general, bond managers are really on top of their individually-held corporate credits (bonds). As you’ll see in this chart, the major long-term trend for HY is down. This is concerning to me.
As prices decline, yields go higher and that spread relative to safer bonds like Treasurys is going up. That is a sign of potential trouble for companies. To this end, the overall default rate is rising and expected to reach a six-year high in 2016 and junk bond stress is spreading beyond energy (according to Moody’s).
In my view, severe stress will present when the money is due to be paid back. Post the great financial crisis, many companies found it easy to refinance and at lower interest rates. However, too many not-so-qualified borrowers found funding and at low rates. A number, including many in the energy space, are on life support and in need of refinancing. Nearly half of the $2 trillion total in the high-yield market is set to mature between 2016 and 2020. Refinancing will be impossible for some (defaults will spike) and be difficult for others. As investors, the probable sell-off will create our next investment opportunity!
Further concerns include the European and U.S. domestic banks that carry loan risk on their books. There is concentrated loan exposure to the oil and gas industry. Banks are highly leveraged businesses. We have reliable word that banks are marking down those loans on their books. These institutions are highly regulated. Once one starts, they all must get real. I expect we’ll see poor bank earnings numbers in April. One has to wonder why they waited until the first quarter of the 2016? 2015 incentive bonus’s anyone.
The behavior of bank stocks (such as SPDR S&P Bank ETF “KBE”) and iShares MSCI Europe Financials ETF (“EUFN”) relative to the S&P 500® (“SPY”) may be telling us something. Consider it a data point and let’s revisit this post come April’s earnings season.
Source: Yahoo! Finance
I conclude that recession holds the key to whether we see a short-term correction in the -15% to -20% range (maybe now behind us) or the -40% to -60% range. Either way, I believe valuations are high. Expect low forward returns from both equities and bonds.
Underweight equity exposure (and hedge that exposure), allocate to bonds (tactically) and overweight to tactical and other liquid alternative strategies and funds, such as managed futures, global macro and long/short equity.
Keep front of mind that we are living in a highly unusual central bank-influenced period in time. Untested and unknown.
The current opinions and forecasts expressed herein are solely those of Steve Blumenthal and are subject to change. They do not represent the opinions of CMG. CMGs trading strategies are quantitative and may hold a position that at any given time does not reflect Steve’s forecasts. Steve’s opinions and forecasts may not actually come to pass. Information on this site should not be used as a recommendation to buy or sell any investment product or strategy.