For nervous investors awaiting the next market slump, analysts at Goldman Sachs say renewed underperformance by corporate bonds versus stocks might offer an unwelcome reminder.
“The magnitude of recent credit underperformance rivals the one we observed Jan. 18, 2018, which served as a useful signal to de-risk equity portfolios,” said John Marshall, managing director for Goldman’s options research team, in a Friday note.
Stocks peaked about a week later. The early February selloff that followed dumped the Dow Jones Industrial Average
and the S&P 500
into correction territory from all-time highs. Although, the selloff was precipitated by fears over inflation and not so much the health of corporate balance sheets, one warning sign was the way equities outpaced corporate debt.
To compare their relative performance of stocks and corporate debt over this year, the Goldman strategists didn’t look at yields for corporate bonds but rather credit default swap indexes that can be used as proxies for the fear of default. The swap index will tighten if investors believe corporate bonds are less risky than before and widen if worries grow.
The five-year spread for the Markit CDX North America Investment Grade Index, an index for credit default swaps linked to high grade bonds, widened to 67 basis points on Thursday, even as the S&P 500 was up by 1.3% for the week.
As a result, investors buying the swap index would be down 2.8% in the past month as of Thursday, even as the stocks corresponding to the issuers in the index were up by 3.5%. In the past, such dislocations saw stocks fall 2.3% on average over the next month.
The widening gap between the two assets recalls the market saying that credit leads equities. Behind this thinking is the idea that more sober-minded bond investors begin worrying about credit risks well before exuberant stock investors take notice.
“In early January, modest widening in credit contrasted sharply with a rapid rise in equity prices. That implied that credit (accurately) did not buy into the enthusiasm of the equity market. In this episode, the divergence has been equally shared between equity rising and credit widening, suggesting a more fundamental disagreement about the direction of risk,” said Marshall.
Matthews said investors dismissed the divergence back in January, citing stronger earnings from the recent tax cuts would benefit stocks more than bonds. Still, “markets mean-reverted in February despite this fundamental argument,” he said.
The worrisome gap building between equities and bonds doesn’t mean, however, stock investors should run for the exit. Rather, it offers a useful short-term signal that corporate paper will begin to offer higher returns than stocks in the next few weeks.
“While we believe today’s observations have implications for broad portfolio risk, at its core, our observation is relative value in nature,” said Matthews.