Junk bonds start flashing a major warning sign
Saying an asset class is giving a warning signal when certain stock sectors have already fallen 20-30% or more is a bit like saying you should try to get out of the way after the car accident has ever happened. It seems a little obvious, but I also think there are signals that are still not where they should be when looking at previous market lows.
The one that I think is flashing the biggest warning sign right now (and the one that could signal that there are more downsides to come) is the high yield spread. Let me explain why.
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I probably don’t need to tell you that until about 6-8 months ago we were in an extended period of historically low interest rates. It didn’t really change much until December of last year. That’s when the Fed signaled that the launch of a new round of monetary tightening was imminent and that rate hikes would begin (about a year too late if you ask me but that’s another story).
Since then, interest rates have been steadily rising and that has sent bonds into the tank. You would think that junk bonds could fall more than Treasuries in this environment, but that has not been the case. They fell at about the same pace, which is because this is a Fed-induced shift in the yield curve.
Here’s where junk bond yields are right now.
The blue line is the yield itself. The orange line is the high yield spread. This is essentially the risk premium that bond investors demand to hold junk bonds higher than Treasuries.
While nominal yields have been climbing since the end of 2021, high yield spreads haven’t really moved since April. When the spreads remain constant, it means that the entire credit quality yield curve is changing. When spreads increase, it means investors are taking risk off the table.
In just two months, the high yield spread has gone from 3.5% to almost 5%. This is perhaps the biggest signal yet that 1) investors are becoming more defensive and 2) this downward move may not be over anytime soon.
Let’s take a look at this historically high yield spread and how it correlates to movements in the S&P 500.
Unsurprisingly, spreads and high yield stocks are highly inversely correlated. Generally speaking, the higher the spread, the lower the S&P 500 falls.
The red line on the chart is a “trigger” level I drew where the high yield spread is 4.5%. Why is this level important? Because, historically speaking, every time the spread has gone above that level, it has ended up going much higher.
The best-case scenario over the past quarter century was the mini bear market of 2018. In this instance, the high yield spread only rose about 5.5% before falling back. The S&P 500 fell about 20%, but quickly rebounded once the Fed pivoted.
In all other cases – the tech bubble, the financial crisis, the Greek debt crisis of 2012, the junk bond crisis of 2016 and the COVID recession, the high yield spread reached at least 9%. In three cases, it exceeded 10%. During the financial crisis, it was more than 20%.
I point this out because look where we are today. The S&P 500 briefly reached 20% of its all-time high and the high yield spread hasn’t even reached 5% yet! The US economy is still in decent shape at the moment, which is probably a big part of why that number hasn’t increased. Some investors are still hoping the Fed can make a soft landing and avoid a recession.
I am not in this camp. The Fed has shown no real ability to steer this ship smoothly in the past. Every tightening cycle has been accompanied by an economic slowdown at the end of it. With the housing market only recently peaking, inflation above 8%, and the Fed expected to raise rates by at least 200 basis points from here, all signs point to a recession ahead. to come.
I bet the high yield spread is heading towards at least 8% again. If that happens, another 10-15% drop would not be surprising.
The only thing that I think sets a real bottom in this market is a dovish pivot from the Fed. I’m not sure if this is the result of lower inflation and less pressure from the Fed or simply the Fed trying to stop losses in risky assets. But that would be the catalyst. It happened in 2018, it happened in 2020 and it will probably happen again.
Sector breakdown of ETFs
That being said, let’s look at the markets and some ETFs.
Energy continues its months-long streak of market leadership. Crude prices, which appeared to be starting to rise, reversed course and helped push stock prices in this sector higher again. Materials stocks, which had also outperformed, appear to be running out of gas here.
The most interesting move came from the defensive sectors. Consumer Staples, which had been one of the best performing sectors in the decline, was hammered by disappointing retail earnings results and fell 7% on the week. It was replaced by health, which had a relatively good couple of weeks, while utilities remained ahead of the pack.
Growth has become a bit mixed. Communications services had actually started to outperform again after months of misery. Consumer discretionary easily became the most disappointing sector on the heels of these retail earnings reports.
There are no real stars among the growth sub-sectors at the moment. Retail obviously got the most attention last week and extended its disappointing run to over a year. Online retail, which had done so well at the start of the pandemic, has almost come full circle and is essentially back to where it was before the pandemic. Some of the other discretionary groups, including leisure, homebuilders and casinos, actually had a relatively better week, but that was mostly masked by retail. The technology simply cannot take off and has been lagging since the Fed announced its tightening cycle last December.
For the first time in a long time, clean energy grew along with the rest of the sector. Nothing else in cycles stands out yet. The most noticeable thing I see here is the sea of red on the right side of this graph. Almost all growth and cyclical areas are seeing exits right now. This is quite the reversal of the multi-year trend we have seen in ETFs where hundreds of billions of dollars poured in, regardless of market performance. I think some of that money has been hanging around with Treasury prices falling almost as much as stocks. Now that Treasuries are regaining some stability, we could finally see investors start to turn away from equities altogether now that there is an acceptable alternative.
Health care was a little choppy for a while, but it had a great week. It was one of the few areas of the market to post gains. Utilities have held firm for several months now, but real estate is still figuring out which direction it wants to go. The biggest driver here is the dollar, which finally took a breather after its strong rally and lost just under 2%. The greenback has correlated fairly steadily with US equities recently and I expect any potential oversold rebound in equities to be met with dollar weakness.