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US credit markets lend fuel to equity rout

Prospect of a risk-off trade could weaken stocks and lift government bond prices

London

EQUITY investors grappling with a technology selloff, trade tensions and hawkish monetary chatter have a new foe to contend with: growing angst in credit markets.

After resisting the full force of the gales that swept through markets earlier this year, corporate bonds are sending ominous messages. Traders are jumping out of the asset class as investment-grade spreads sit near their widest in six months and yields rise to the highest in more than six years - just as stock investors seek to recover from the first S&P 500 correction in two years.

"If credit spreads widen, the equities with bad balance sheets will underperform," said Louis de Fels, a Paris-based fund manager at Raymond James Asset Management International. "We're quite cautious on the quality of the assets."

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Corporate bonds held by smart money have historically proven a leading indicator for the direction of stocks. That may spell disappointment for investors heeding Wall Street advice to shift towards equity, a late-cycle outperformer.

"Credit leads equities and will underperform," said Andrew Brenner, the head of international fixed-income at Natalliance Securities in New York, citing Federal Reserve hikes, signs of softer US output and corporate sales of short-term US debt. "We expect equities to catch up on the downside."

For now, stock investors appear sanguine. US equity funds took in a record US$34.5 billion in the week to March 14, compared to just US$2.4 billion for bonds, according to Stanford C Bernstein & Co. That brings the quarterly total for debt funds to US$37.3 billion, the slimmest quarterly addition since the three months ended December 2016, the data show.

Credit softness first emerged in some of the world's most popular exchange-traded funds and has continued to worsen. Short interest on the iShares iBoxx Investment Grade Corporate Bond ETF, ticker LQD, relative to its US equity ETF counterpart is now at its highest on record.

"When we see a widening of credit spreads, it's always a problem," said Matt Maley, a Miller Tabak equity strategist. "The cost of carrying leverage goes up and people's models say that they need to unwind."

While credit weakness and a junk bond selloff in November proved to be a headfake, "this time around, I'm more nervous about some weakness in investment-grade credit seeping into big-cap stocks", Peter Tchir, the head of macro strategy at Academy Securities Inc, wrote in a note.

The telltale sign? Underlying corporate bond spreads have widened while credit default swaps have stayed largely steady. Higher dollar funding costs are now beginning to curb appetite for credit risk - a bearish signal missing from derivatives, for now likely thanks to technical factors, Mr Tchir noted.

Add weakness in the primary market, and pressure on credit markets is likely to endure, he said. That increases the prospect of a risk-off trade that would weaken stocks and lift government bond prices.

In any case, equity investors had better make peace with cracks in credit markets and any ensuing increase in debt financing costs for companies.

Money managers in high-grade credit have pared their exposure to the lowest since October 2010 as they brace for interest-rate increases, according to a Bank of America Corp survey this month. Funds that reported inflows fell to a net 29 per cent, the lowest in two years, the survey found.

"We are seeing clear signs that US credit is in the midst of the transition away from global QE as inflows to high-grade continue to decline," strategists at the bank led by Hans Mikkelsen wrote in a note on Sunday. BLOOMBERG

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