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All the nightmares for stock investors start in the bond market
[NEW YORK] If there's one thing the prophets agree on, it's that the end will come in the bond market. Even for stocks.
Prophesies of doom are everywhere. There's billionaire investor Stan Druckenmiller, who says our "massive debt problem" will ignite a crisis. Oaktree Capital's Howard Marks warns that public and private debt will be "ground zero when things next go wrong." And Citadel's Ken Griffin, who sees a binge ending badly.
If you're an equity investor, all the hectoring has probably left you frazzled, staring anxiously at fixed-income markets for early signs of the apocalypse. So it's no mystery why the sight of 10-year Treasury yields spinning higher at the fastest rate in two years was enough to send the S&P 500 to its worst two-day tumble since May.
"There are a lot of people waiting for the world to end because of this bond market," said Brad McMillan, chief investment officer for Commonwealth Financial Network, which oversees US$156 billion. "Low rates will keep going forever - a lot of justification for high valuations is based on the assumption. That assumption is largely broken."
To be sure, the biggest weekly decline in a month for the S&P 500 wasn't that big - just 1 per cent. Which is testament to how hard it's been to worry stock traders. If this episode is different, if it rises above past threats that couldn't lay a glove on stocks - trade wars, emerging economy implosions - it's because it has its root in something investors have trouble brushing aside: credit.
Any number of bond market hypotheticals are capable of terrifying stock bulls. They pertain to the startling amount of credit swirling around the US economy - and the possibility it will turn sour. The government's budget deficit has swelled, contributing to the country's debt load, now at US$21.5 trillion.
Meanwhile, corporate America has gone on a borrowing spree to take advantage of near-record low rates. Excluding financials, S&P 500 companies have more than doubled their borrowings to US$5 trillion over the past decade, data compiled by Bloomberg show.
Should interest rates rise and growth slow, companies are bound to see to their financial soundness deteriorate. More than US$1 trillion of investment grade corporate bonds could be cut in the next downgrade cycle, according to analysis this week by Morgan Stanley.
"Leverage is near all-time highs, and companies used tax reform proceeds for buybacks instead of paying down debt," said Max Gokhman, head of asset allocation for Pacific Life Fund Advisors, which manages US$40 billion. "More than triple the debt that came due in 2018 will be due each year from '19-'21. If yields go up, there's real concern about companies' ability to reissue and keep their leverage."
For now, pain in stocks has been limited. The S&P 500 is 1.5 per cent from a record reached Sept 20. Dig a little deeper and there are signs credit concerns are being felt. A basket of companies with stronger balance sheets compiled by Goldman Sachs Group Inc. is up 12 per cent since December, compared with 6 per cent for the weaker group.
It's a departure from the early part of this bull market, when financially less stable firms consistently beat their sturdier counterparts. During the eight years from March 2009, the weaker cohort topped the stronger by 10 percentage points annually.
One thing that clearly bothers equity investors is how quickly turbulence broke out in fixed-income markets.
The Merrill Lynch MOVE Index tracking Treasury volatility rose almost 20 per cent this week, the biggest jump since 2015. Yields rose across the curve on the back of strong US economic data and hawkish comments from US Federal Reserve Chairman Powell, forcing equity investors to reevaluate the higher rate environment.
The Russell 2000 index of small-caps, where unprofitable companies have ballooned under the cover of rock-bottom borrowing costs, fell 3.8 per cent over the week, the most since March. It's down three weeks in a row, the longest streak of losses since November 2017.
‘‘You definitely have to look at the capital structure of all the companies you invest in," Jeanie Wyatt, founder and chief investment officer of South Texas Money Management, which manages US$3.8 billion, said by phone. "How much debt do they have, how much of it is short-term? That becomes critical."