Will 2018 be the year the stock market rally screeches to a halt?
It may be, if those analysts who are cautioning that a bubble is forming in credit markets are right and companies are overextending themselves to a degree that could spell trouble ahead.
Most analysts agree that the credit market has been speeding ahead at a bubble-like pace. Companies have been piling on debt in recent years to take advantage of low interest rates, or more recently, to get ahead of a series of well-telegraphed interest-rate hikes.
If their borrowing is simply to refinance existing debt at lower interest rates, it’s a positive for balance sheets. But many companies have borrowed to raise funds for shareholder rewards, and that may come back to bite them if rates were to spike.
For example, Apple Inc.’s AAPL, -1.08% debt may be highly rated, just two notches below triple-A at AA+ at S&P Global Ratings, but the technology giant continues to ride the borrowing bandwagon as it looks to fund its massive share buyback program. Apple issued $7 billion of debt in November, two months after selling $5 billion worth of corporate bonds and several months after adding more debt.
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The U.S. primary corporate bond market is currently at record levels. The investment-grade market saw $1.44 trillion of issuance in 2,127 deals through December 26, topping the record $1.34 trillion recorded in 2016, according to data analytics company Dealogic.
The high-yield market has chalked up $266.3 billion of debt in 469 deals, making it the fourth-biggest year for issuance, according to Dealogic. The high-yield record goes to 2012 when issuers sold $321 billion of debt in 604 deals.
Combined investment-grade, high-yield and FIG issuance—FIG is financial institutions group—is a record $1.71 trillion, topping the previous record of $1.57 billion set in 2015.
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What’s starting to worry some analysts is that despite the fact that the Federal Reserve and other central banks are draining liquidity from the marketplace and the yield curve is flattening, near-record credit market valuations suggest investors haven’t prepared for any potential speed bumps.
One sign of this complacency, is how narrow the spread is between yields on speculative grade, or “junk” bonds, and corresponding risk-free Treasury notes. S&P Global Ratings said Tuesday its speculative-grade composite spread tightened by three basis points (0.03 percentage points) to 399 basis points, well below the five-year moving average of a 528 basis-point spread.
“We think there is way too much complacency regarding what is a notable and growing shift in central bank policy globally,” Morgan Stanley credit strategist Adam Richmond wrote in a recent note to clients. “Markets expect a seamless unwind [of quantitative easing]. We don’t.”
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The yield curve describes the spread between longer-term and short-term Treasury yields. Longer-term yields are usually higher than shorter-term yields, because continued economic growth leads to higher interest rates down the road, and an increase in inflation expectations relative to present levels.
Banks and lenders love a positive sloping, or steep, curve because they can sit back and make money by funding the purchase of longer-term assets, such as loans, with shorter-term interest liabilities, a so-called “carry” trade. The steeper the curve, the more money they make.
The assumption that the yield curve will finally begin to steepen, especially since President Donald Trump signed the $1.5 trillion tax cut into law, has helped propel the SPDR Financial Select Sector exchange-traded fund XLF, -0.71% by about 10% over the past three months, while the S&P 500 index SPX, -0.52% has gained 7.4% and the Dow Jones Industrial Average DJIA, -0.48% has tacked on 11%.
When a curve flattens, or inverts—when shorter-term yields are above longer-term yields—it often foretells economic weakness.
Many yield strategists say the current flattening trend is not about the economy, or about the traditional drivers of yield spreads. Longtime Wall Street veteran Jeffrey Saut, chief investment strategist at Raymond James, has said the flattening is more a reflection of money flows, and shows strong demand for longer-term debt, including the riskier, high-yield variety.
“Verily, we do think it is different this time,” Saut wrote in a recent note to clients.
But as legendary bond investor Bill Gross, who currently manages the Janus Global Unconstrained Bond Fund, said in his December investment outlook, it doesn’t matter why the yield curve flattens or inverts, or what the message about the economy might be.
“Our entire financed-based system...is based upon carry and the ability to earn it,” Gross wrote. “When credit is priced such that carry can no longer be profitable (or at least grow profits) at an acceptable amount of leverage/risk, then the system will stall or perhaps even tip.”
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One example of a company with high leverage is Valeant Pharmaceuticals International Inc. VRX, -1.80% Although the drug maker has paid down debt maturing in the near term, some of that was done by borrowing more money. The junk-rated company still has over $27 billion in debt, with leverage well above “ideal” levels, according to J.P. Morgan.
Toy maker Mattel Inc. MAT, +0.26% had its credit downgraded to junk status last week by Moody’s Investors Service, given high leverage, a weak operating performance and the need to issue even more debt to maintain its liquidity position.
The good news is that many feel conditions are ripe for the curve to finally start steepening. The bad news is, they have believed that was the case ever since Trump was elected, but it has actually gone the other way. The Republican tax bill is supposed provide a jolt to the economy, which should in turn steepen curve, but it hasn’t.
The spread between the 10-year Treasury note TMUBMUSD10Y, +0.00% and the 2-year Treasury note TMUBMUSD02Y, +0.00% fell to 57 basis points last Friday from 59 basis points on Thursday, even after Trump signed the bill Friday morning. The spread has further narrowed to 51 basis points on Wednesday, down sharply from 128 basis points on Inauguration Day and from 78 basis points six months ago.
Morgan Stanley interest rate strategist Matt Hornbach expects the curve to continue to flatten, to zero by the third quarter of 2018, and to fully invert by the fourth quarter.
Why does that matter to the stock market?
“It starts the clock ticking, on when [companies] will no longer be able to add leverage,” said Brian Reynolds, asset class strategist at Canaccord Genuity. “If they can’t borrow, they can’t push up their stock price.”
Many believe that even if the clock is ticking on the credit bubble, the alarm won’t ring for quite a while for stock market investors.
Tom Barkley, finance professor at MBA@Syracuse, the online MBA with GMAT waiver program from Syracuse University, said that although debt-to-earnings ratios have doubled since the 2008-2009 credit crises, he believes the rush to issue debt still makes sense given that rates are still historically low. And as long as the market makes sense, it has room to continue.
“I don’t think the markets are going to turn around in the next three-to-six months,” Barkley said. “I would forecast one-to-two years.”
If and when the bubble does pop, however, the deleveraging by lenders could create a credit crunch the likes of which haven’t been seen since the Great Recession. Without credit, repatriated earnings taxed at lower rates may not be enough to fuel the expansion that investors appear to have priced into the major market indexes, which have shot up over the past year to record highs.
“Leverage is terrific when it goes in your favor, it’s a disaster when it goes against you,” Reynolds said. “People will start looking for safety, and equities are not considered safe.”