Financial Liquidity Withstands Equity Volatility for Now
Higher interest rates and trade related frictions, including the effective tax hikes brought on by the imposition of tariffs, have lowered the market value of U.S. common stock by 8.1% from its current zenith of September 20, 2018. Thus far, systemic financial liquidity has yet to suffer materially from the latest bout of equity market volatility. However, liquidity will be adversely affected if a further weakening of the equity market substantially increases the cost of both equity and debt capital.
A persistently volatile equity market risks swelling the uncertainty surrounding the valuation of business assets. In turn, capital spending and business outlays on staff may be less than otherwise.
Once equity volatility widens credit spreads substantially, default risks will rise. For one thing, heighten uncertainty over the value of business assets and costlier capital may discourage financially strong companies from acquiring weaker businesses. In addition, the diminution of liquidity will make it more difficult for financially stressed companies to sell assets for the purpose of raising badly needed cash.
Utility Rally amid Equity Slump Betrays Growth Concerns
Since the Federal Open Market Committee’s rate hike of September 26, the broadest readily available valuation of the U.S. common equity market was recently down by 7.2%. Among the deepest post September 26 declines are NASDAQ’s 8.1% slide that exposed the vulnerability of elevated price-toearnings ratios to expectations of high interest rates. Nevertheless, the shocking 12.7% plunge by the PHLX index of semiconductor-industry stock prices shows that greater uncertainty over future profits also contributed to the sell-off of technology shares.
The setbacks of 11.0% by the Russell 2000 stock price index for small- to mid-sized companies and the roughly 9.3% drop by Value Line’s geometric stock price index warn of possibly much wider credit spreads for high-yield bonds and loans. The record shows that the investment performance of high-yield credit is more closely aligned with movements by the Russell 2000 and Value Line indices than with the S&P 500.
The 13.4% plummet by the PHLX index of housing-sector share prices since September 26 reflects expectations of fewer home sales at possibly lower prices going forward. An increase by the average 10- year Treasury yield from the 2.37% of 2017’s final quarter to the 2.93% of 2018’s third quarter helped to slash the annualized pace of unit home sales by 6.3% from fourth-quarter 2017’s current cycle high. Once the moving three-month average of unit home sales falls at least 8% under its current cycle high, the 10-year Treasury may be close to peaking, but only if inflation expectations remain well contained.
Amid the equity slump, the Dow Jones Utility Average has advanced by 5.6% since the latest Fed rate hike. Ordinarily, expectations of higher interest rates would lower the market value of public utility shares. However, because utility shares also tend to perform relatively well during a slowdown in business activity, the latest rally by the utilities indicates that the equity market senses a possible marked deceleration of corporate revenues and earnings.
The latest rally by utility stocks also stems from how any material deceleration of business activity would probably trigger a substantial drop by interest rates, including an easing of monetary policy. In part, the current upturn by utility share prices may be in anticipation of a slowing of domestic expenditures that prompts a drop by interest rates.
Finally, the 9.3% retreat by the KBW bank stock price index showed that Fed tightening will not always enhance bank earnings. Not only does a flattening of the Treasury yield curve squeeze bank profit margins, but any loss of business activity to higher rates risks a slower rate of growth for bank lending to consumers and businesses, never mind a possible increase in delinquent loans.
High-Yield Shows a Muted Response to Volatile Equities
For a fourth time during the current business cycle upturn, a deep sell-off of equities and a jump by the VIX did not trigger a commensurate widening by the high-yield bond spread.
The relationship between the high-yield bond spread and the VIX is typically very tight. For 79% of the 172 months since the end of 1989 showing a VIX that exceeds its long-term median, the high-yield bond spread also tops its long-term median. Similarly, for 78.5% of the months where the VIX is less than its long-term median, the high-yield spread is under its median. Both of these percentages are very close to the 0.81 correlation between the high-yield bond spread and the VIX.
October marked the fourth time during the current business cycle upturn where the high-yield bond spread predicted by the VIX exceeded the actual spread by more than 200 bp. In terms of month-long averages, the previous three incidents occurred in February 2018, August-September 2011, and May 2010. The third month following the end of these three episodes revealed an average decline by the VIX of 9.0 points and an average 0.9% increase for the market value of U.S. common stock. Could it be that the high-yield bond spread’s relatively muted response to October’s equity market turmoil will have again correctly indicated only a temporary sell-off of equities?
If, as expected, profits grow and the high-yield default rate declines from September 2018’s 3.1% to a predicted third-quarter 2019 average of 1.8%, October 2018 should mark the fourth incident since the end of the Great Recession where a steep jump by the VIX relative to the high-yield spread was followed by lower VIX and ultimately higher share prices.
Note that 84% of the year-to-year declines by the high-yield default rate since 1982 have been accompanied by a year-to-year increase for the month-long average of the market value of U.S. common equity rose. However, it should be added that the market value of U.S. common stock rose from a year earlier in 78% of the 429 months since year-end 1982.
The VIX recently equaled 23.5 points. In terms of month-long averages, when the VIX was previously between 22.0 and 24.0 points, the high-yield bond spread averaged 590 bp, which was much wider than the 386 bp of October 24.
Nevertheless, a now atypically thin high-yield spread given the well above-trend VIX warns of much wider high-yield credit spreads if equity market volatility remains elevated. A further weakening of equities and substantially wider spreads might offer the FOMC enough reason to keep fed funds in its current range of 2% to 2 1/4% through year end 2018.
All Will Be Well if Profits Grow
The realization of a predicted decline by the high-yield default rate requires the avoidance of a jarring climb by leverage. One aggregate approximation of corporate leverage employs the moving yearlong ratio of outstanding nonfinancial-corporate debt to the pretax profits from current production of nonfinancial corporations. The ratio’s numerator is from the Federal Reserve, while the denominator is found in the BEA’s National Income Product Accounts. The ratio shows a strong coincident correlation of 0.83 with the default rate.
Any forthcoming rise by the ratio of corporate debt to pretax profits would challenge forecasts of a declining default rate over the next 12 months. Disruptive ascents by the leverage ratio are always the offshoot of much reduced profitability. The record shows that each of the leverage ratio’s previous five spikes to a reading above 725% was associated with at least a 5% drop by profits from current production from its then record high. Thus, another rising trend for the default rate should be avoided provided that profits avoid a material contraction of a 12-month duration.
More serious and enduring equity corrections (and rallies) are typically accompanied or led by debt market shakeouts.