April 3, 2019 / 6:52 PM / 5 months ago

Junk bonds suggest U.S. stocks may have further to run

NEW YORK (Reuters) - U.S. stocks just wrapped up their best quarter in nearly a decade, coming within a stone’s throw of a record high.

FILE PHOTO: Street signs for Broad St. and Wall St. are seen outside of the New York Stock Exchange (NYSE) in New York, U.S., March 7, 2019. REUTERS/Brendan McDermid

Junk bonds did them one better, regaining record levels and then some. Given the long-running correlation between the two asset classes, that could mean stocks will soon be back in record territory as well, keeping alive a bull market run now stretching into its second decade.

“We think this cycle has a lot more time than (others) think,” said Krishna Memani, chief investment officer at Oppenheimer Funds. “It’s not ending in 2019 and it’s not ending in 2020. It has a few more years to go.”

Both stocks and their closest associates in the bond market - the high-yield debt issued by companies with less-than-stellar credit ratings called junk bonds - have come charging back in the first months of 2019 after taking a drubbing at the end of last year. The S&P 500 has gained 15% this year, and the ICE Merrill Lynch U.S. high-yield index has returned 7.6%.

The clearest catalyst for the turnaround is the change in posture from the Federal Reserve, which has taken an open-ended hiatus from interest-rate hikes and will soon stop letting bonds roll off its balance sheet. The ensuing drop in yields on safe-havens like Treasuries has been a tailwind for riskier assets.

While the two frequently move in lockstep, junk bonds have often taken the lead in demarking major turning points or signaling that both sectors may be heading into uncharted territory.

A decade ago, for instance, high-yield bonds began their rise from the financial crisis more than two months before the S&P 500 and the Dow Jones Industrial Average found their bottoms. More recently, in the big corrections suffered by both markets in 2015-2016 and in early 2018, junk bonds regained record levels weeks before stocks did.

In the current case, the high-yield index has been striking new tops since early February. Meanwhile, the S&P, up 22% from its December low, is about 2% short of last fall’s record and the Russell 2000, the benchmark for small-cap stocks, is around 10% below its high-water mark.

Graphic: Junk bond recovery signals more gains for stocks, click tmsnrt.rs/2I9iMCJ

TOO GIDDY?

The drive higher in both markets is occurring against the most uncertain economic backdrop in several years, a suddenly clouded horizon that drove the Fed to cut short a three-year tightening cycle. Last month the spread between 3-month Treasury bill yields and 10-year note yields briefly inverted, commonly seen as a signal of an oncoming recession.

Of even greater importance for stocks and high-yield bonds, the outlook for corporate profits - the fundamental driver in both markets - is weakening. S&P companies’ earnings may have fallen in the first quarter for the first time since 2016, according to Refinitiv data, and full-year 2019 profit growth is seen as less than half the pace of 2018’s tax-cut fueled pace.

In that context, some investors are skeptical that financial and economic conditions will provide sustained support for a run-up in stocks.

“While the economic data is coming across as mixed, the market and investors are willing to give it the benefit of the doubt,” said Lale Topcuoglu, senior fund manager at J O Hambro Capital Management Group in New York.

“Both (credit and equity) markets are getting onto this weird cycle where they’re pointing fingers at each other in the absence of any economic news.”

Graphic: Junk bond credit spreads are narrowing again, click tmsnrt.rs/2CQ1V4s

OPTIMISM PERSISTS

Still, equity markets are flashing green, and market volatility, which rises when investors are anxious, is not far off last fall’s lows when stocks were last at a record.

While such measures of equity investor sentiment do not yet fully reflect the recovery in stocks, as confidence rises it could lift them further, said Charlie Bobrinskoy, vice chairman at Ariel Investments in Chicago.

“I’m worried that the high-yield market is a bit overpriced,” he said. “Having said that, I’m still pretty confident about stock prices for the rest of the year.”

Credit spreads, or the amount paid to investors above Treasury yields to compensate for holding riskier debt, are also cause for optimism.

Even when 3-month Treasury yields briefly overtook 10-year rates, junk bond spreads remained relatively narrow. That also shows investors aren’t overly worried, said Keith Lerner, chief market strategist at SunTrust Advisory Services in Atlanta.

With spreads continuing to tighten, keep an eye on financial stocks in particular, said Jim Paulsen, chief investment strategist at the Leuthold Group in Minneapolis. Spreads and the total return of the S&P 500 Financials index are closely correlated, but financials have not yet fully recovered from December’s rout even as junk bonds have made new highs.

“There’s some catch-up room in those stocks relative to what credit spreads are already saying,” he said.

Reporting by Kate Duguid and April Joyner; Editing by Dan Burns and Phil Berlowitz

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