Unsound Credit And Risk Assets – How Serious Is The Situation?

It is a bit incongruent that there is seemingly still so much nonchalance about the market’s prospects while so many obvious warning signs are in evidence. One aspect of the stock market’s recent move strikes us as a bearish confirming indicator, namely the fact that stocks are now finally catching up to the trend in risky corporate debt.

A lag between the trend of the latter and the trend of the former is typically seen at every important market peak. Once stocks do begin to follow junk debt lower, it is basically an “endorsement” that shows that one has to take the trend in bonds seriously. In other words, if it was ever contained, it isn’t any longer.

6-SPX and HYG

The S&P 500 compared to junk bond proxy HYG (an ETF holding high yield bonds, not adjusted for dividend income). Junk bonds have been leading the way lower since mid 2014 – click to enlarge.

Conclusion

Based on the fact that the recent decline in junk bonds and stocks is different from the 2007/8 event in terms of the fundamental backdrop, it is widely held that has to be less serious. This assessment may turn out to be wrong. In fact, we believe that the crisis has never really ended – it has merely been masked by papering it over with enormous money supply inflation (US money TMS-2 +116% since 2008) and deficit spending (total federal debt +92% since 2008). Some of the risks have been shifted from the banking sector to the government and new risks have been incurred by other market participants.

Broad money supply growth remains relatively brisk, which normally lowers the prospects of a very large decline in risk assets, but then again, growth in narrow money AMS (resp. TMS-1, close to M1) has slowed considerably more. The slowdown in its growth rate may already suffice to capsize the bubble boat (we plan to soon discuss in these pages in what way these measures differ from an analytical perspective).

It was easier to pinpoint the weaknesses and guess what could happen prior and during the 2008 event, as the bubble was concentrated in a single highly important sector. By contrast, the echo boom has been somewhat more opaque, as bubble activities seem to be spread across numerous sectors – aside from the fact that malinvestment in commodities and especially in the energy sector has obviously gone through the roof in recent years. In this sense, what is happening in energy sector debt strikes us as likely just the tip of the iceberg.

Charts by: StockCharts, St. Louis Federal Reserve Research

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Disclosure: None.

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Gary Anderson 5 years ago Contributor's comment

So bank funded investors have been fooled into thinking that the junkiest bonds are not so junky? Wow, that story played before. Amazing that the Fed probably thought all this structured finance was good risk. I wonder if they had their hand in the mispricing of this risk too, just like the subprime bonds back in 2008?