Could today’s credit bear market be a signal of equity market wobbles to come?
Investment grade credit markets have been in a bear market since the end of January. There’s no official definition, but credit spreads have been gradually widening since that moment, resulting in negative returns for investors and higher funding costs for borrowers.
This probably comes as a surprise for equity market investors. Returns haven’t been great, but they’re nothing like the traditional definition of an equity bear market – a 20% fall.
Credit conditions are a really important leading indicator for economic growth
But here’s the interesting bit. In a world weighed down by debt, we think credit conditions are a really important leading indicator for economic growth and, by association, equity markets. Our team of economists focus on bank surveys that ask about lending conditions – are they loosening or tightening? Here, there’s very little to worry about right now, with lending conditions looking broadly stable.
But we could also use public credit markets as a gauge of lending conditions, with higher funding costs for borrowers a potential warning flag. In this context, should equity investors be worried about the credit spread widening we’ve seen this year?
I’ve taken spread data for global credit markets since just before the financial crisis and highlighted the four periods when similar spread widening occurred.
What happened to equity markets following these periods? I’ve used the S&P 500 in the US as a proxy for global equity market sentiment, and shown in the table how much this index fell following each period of credit widening.
|Credit Correction||Subsequent S&P 500 drawdown|
* This drawdown occurred during the credit correction
As someone who studied maths at university, I know we shouldn’t put much weight on just four data points. But the statistical experience is consistent with my hunch that tightening credit conditions should eventually weigh on global growth and equity markets.
On this basis, I would not be comforted by equity market resilience in the face of a credit bear market, rather I am thankful that it gives the opportunity to reassess equity exposure before potentially suffering heavy losses.
True diversification requires looking for independent return streams. You normally cannot rely on the weather, but in investments that lack of reliability is an interesting feature.
“You only find out who is swimming naked when the tide goes out” (Warren Buffett, 2001). In bull markets, market risk is often the most important driver of performance. However, we should pay attention to bottom-up investors in both equity and credit markets as they can add value in spotting turning points and identifying areas where investors may find themselves overexposed.