U.S. debt market jitters signal caution for high-flying stocks

Globe and Mail

5 days ago

Investors are backing out of or taking active bets against high-priced corporate credit, where they anticipate a correction in response to signs of slowing economic growth that could eventually impact stocks.
In interviews and client research, global asset managers and some of the world's biggest banks cautioned that credit pricing had reached levels consistent with a much stronger economic outlook than official forecasters anticipate for this year.
'We've turned very defensive in terms of developed market credit,' said Mike Riddell, lead portfolio manager for strategic bond strategies at Fidelity International.
'We have zero exposure in terms of cash bonds and are short high-yield,' he added, referring to the use of derivatives products to bet an asset class will perform badly.
The spread that measures the premium corporate bonds pay in interest over government debt, the main valuation metric for credit, dropped to just one basis point above its 1998 low on Jul. 29, Reuters analysis showed.
Markets are rallying worldwide, with European stocks hitting their biggest weekly gain since late April and Wall Street indices close to record highs, but investors and analysts said credit was the strongest example of exuberance.
As U.S. economic data softens, investors said corporate credit was most vulnerable to a sustained slowdown in the world's largest economy that could hit global growth, with equities likely to fall in turn.
Before 2018's U.S.-China trade war slump, 2022's rate rise rout and a similar shake-up in late 2023, a popular exchange-traded fund tracking high-grade corporate credit fell some time before world stocks.
Stuart Kaiser, head of U.S. options strategy at Citi, said the bank's derivatives desks had in the last few weeks begun seeing significant demand from asset manager clients for products that bet against the performance of that iShares index or gauges of junk bonds.
'It is probably macro investors taking a directional view or putting on a hedge against the rally we've seen in risk assets,' he said.
'The fact people are now hedging credit risk tells you they see reasonable downside to equity markets over the next three months.'
Lombard Odier Investment Managers' head of multi-asset Florian Ielpo said credit was 'leading the market' already, based on shifts he had spotted under the surface of headline pricing.
According to his own analysis of global credit indices, he said, the proportion of business bonds where spreads were still narrowing had fallen abruptly from 80 per cent to 60 per cent in the five days to August 4.
'This is a significant move in the data and one you cannot ignore,' Ielpo said, because it was not usual. He had just trimmed back a bullish derivatives trade on credit, he added.
Amundi Investment Institute's head of developed market strategy Guy Stear said high-yield debt, which is dominated by borrowers from economically important industries, was looking most vulnerable to a correction that stock markets might follow.
He said he expected, as early as October, to see jumps in high-yield refinancing costs and defaults driven by tariff-related cost increases or cash flow pain, sparking anxiety about jobs, investment and growth.
'When credit markets come under pressure eventually equity markets come under pressure as well,' he said.
Broadly, credit spreads where they are now imply a global growth forecast of almost 5 per cent, which is far above current levels, UBS strategist Matthew Mish said in a note to clients.
The International Monetary Fund forecasts 3-per-cent global growth this year. 'The investment-grade market is pricing a Goldilocks scenario,' Russell Investments global head of fixed income and foreign exchange strategy Van Luu said, adding he did not think this was accurate and had taken an underweight stance on credit as a result.
The IMF has put 40-per-cent odds on the U.S. entering recession, with risks rising for other major economies if a weakening trend for the dollar that has boosted exporter nations goes into reverse.
In a note to clients this week, UBS' Mish said: 'many risk assets are pricing in a higher growth outlook than we expect. However, credit markets are outliers.'
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.