So Goldman has something new out on Tuesday about ISM peaks and what generally happens thereafter (i.e. when things begin to “slow down”).
This is one of those notes where there’s a lot of ostensibly interesting color and there are plenty of pretty charts, but it’s not 100% clear whether or not the analysts have actually said anything worth saying. Consider this bit for instance:
Global growth momentum appears to be slowing. The ISM has likely peaked, and the US labour market has tightened further. We appear to be in the “slowdown” phase. Historically, slowdowns have not necessarily been bad for risky assets, unless a recession results.
That’s the whole premise behind a 9-page note and that last bolded passage is akin to saying something like this:
Historically, nose bleeds have not necessary been bad for people’s health, unless it turns out to be Ebola.
Here’s what that looks like in chart form:
Having read all manner of peer-reviewed social science journal articles, I can tell you from experience that this is what happens when you do a lot of good research and make some really neat-looking charts, but ultimately you end up saying something that’s intuitive.
Because you know, it stands to reason that a decelerating ISM manufacturing index would end up being a lot worse for risk assets if that deceleration presages a recession as opposed to if it doesn’t. Again, intuitive.
So given that, I think it’s probably best to skip the self-evident stuff and move straight to something that, while also largely intuitive, is at least not so no-brainer-ish as to be completely useless to investors.
We’ve talked a lot about HY in these pages and how, simply put, further spread compression (i.e. MOAR rallying) doesn’t seem feasible from here given that the last time spreads were this tight, oil prices were somewhere in the neighborhood of $90/bbl (and then there’s high leverage and all manner of other reasons to think the rally is overdone).
Additionally, we recently noted HY’s remarkable resilience relative to equities during last week’s selloff – you’ll recall from “Wednesday’s Equity Bloodbath Produced A 94th Percentile Moment,” that, to quote Goldman, “the weekly outperformance of HY cash vs. the S&P 500 ranked in the 94th percentile vs. the history of the past two years while the synthetic CDXHY vs. SPX outperformance ranked in the 77th percentile.” That, we said, seemed to suggest that the VIX spike and concurrent S&P dip hadn’t shaken traders out of some of their profitable, “free” money positions in credit.
Well, with that in mind, do consider the following excerpts from the above-mentioned Goldman note because as you’ll see, HY does indeed tend to be a leading indicator for equities during late ISM-cycle environments, a fact which underscores Richard Breslow’s contention that “you’re better off watching some of the slower moving credit spread indexes to see how deeply these cuts are being perceived by real investors.”
US High Yield spreads
As with equities, the other key risk asset class, credit, generally suffers its largest losses when recessions result (Exhibit 9). When concerns about growth and recession risk rise during a slowdown phase as the ISM decelerates, credit spreads tend to gradually widen. Historically, a rise in US high yield spreads to roughly 500bps has signaled potentially more pain ahead, and generally preceded equity drawdowns during/after a late cycle environment (Exhibit 10). Notably, not only does a rise in credit spreads to 500bps during the late cycle tend to indicate that equity risk is high, but a narrowing in credit spreads of close to 500bps during recovery without them breaking through this level also seems to indicate that equity risk is high.
Given anchored real rates relative to history, a strong search for yield and a liquidity structure of the market that has changed since the financial crisis, could it be that this threshold level is different this time? Possibly, but in any case we think credit spreads would likely need to rise from here to signal concern more broadly for risk assets.
Meanwhile, if we are heading into a recession, HY spreads sure as hell aren’t acting like it…