This week’s chart takes our second look at valuations for 10-year Treasuries, the S&P 500 Index and high yield bonds using the “Fed Model,” which compares the 10-year Treasury yield with the S&P 500 earnings yield (reciprocal of the P/E ratio). We added high yield bonds to the mix in order to gauge relative value between equity and credit risk. I argued in early 2015 that through this lens, widening credit spreads (often a leading indicator of higher equity market volatility) signaled more challenging times ahead for equity markets. Equity and high yield credit performance did struggle until early 2016, when oil prices ultimately bottomed.
The swift and dramatic widening in risk premiums last quarter was again accompanied by a steep decline in oil prices. Lower energy prices stirred fears of higher defaults among increasingly vulnerable corporate borrowers (especially at the growing BBB-rating level), and could potentially push an already wobbly global economy into another downturn.
Despite the sell-off in equity and credit markets last quarter, risk premiums today for both equity and high yield credit stand remarkably close to early 2015 levels. While the ending point is nearly identical, the path to get here has not been. High yield credit spreads have been nearly twice as volatile as equity risk premiums since early 2015. Increasing leverage on corporate balance sheets, challenging corporate bond liquidity conditions and greater sensitivity to oil prices, all factor into this changing relationship. The bottom line for investors from our 2015 Chart of the Week is still the case today – watch investment-grade and high yield corporate credit markets as leading indicators for near-term equity market performance.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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