Is corporate leverage the new threat to equities?

Wall Street managed something of a rally into the Thanksgiving celebrations, however, the recovery made little of a dent in global equity markets as the MSCI All World Country Index has lost about 2.5% in the days leading up to the holiday. Equity investors continue to be impacted by concerns of slowing economic growth. The fall in the oil price has led to a general selloff in high yield corporate bonds, particularly in that sector.

The technology sector has given up all this year’s gains, Apple’s trillion-dollar market cap is gone as investors worry about weakness in handset sales. At the start of the week, the monthly National Association of Home Builders survey added to fears that higher rates are slowing the economy. The past few years of ultra-low interest rates have led to an explosion in corporate debt as companies have replaced equity with debt. The Financial Times pointed out the other day that the proportion of buyouts with high leverage is back to levels seen ahead of the 2008 crisis.

We have discussed in the past how the market cycle works. At the start of an economic cycle, debt leads equity prices and likewise as monetary policy tightens credit markets weaken and equity markets follow. Leverage increases during the period of economic growth fuelling rise in risk assets. Leverage leads to a rise in interest rates and eventually, this brings an end to the growth as companies look to deleverage as debt becomes less affordable.

For equity markets to start to recover we will need to see high yield credit markets stabilise. The fundamentals for equities remain supportive. The US economy is likely to grow between 2.5% and 3% in the current quarter. Company earnings may be slowing but they are still growing. Valuations are far more attractive than they were to reflect the slowdown in earnings growth.

Many equity investors anticipated the conclusion of the mid-terms would encourage people back into the market, that did not happen. Thanksgiving again failed to provide a catalyst for a rise in equity prices. As traders come back from the brief holiday, the focus will turn to hopes for a Santa rally. What may offer something of encouragement, the Vix index has fallen in the past few days despite the global selloff. The converse of what occurred in September as equity markets rose investors wanted to pay up for protection. We then saw what happened in October, we shall see if the reverse happens in December.

Posted on November 22, 2018 .