U.S. equities have been seen as something of a sacred cow over the past several years, weathering any and all storms and digesting periodic shocks with relative alacrity.
That is until February 5, when the rebalance risk inherent in levered and inverse VIX ETPs was finally realized, leading directly to the largest VIX spike in history and catalyzing a veritable cascade of forced de-risking as CTAs and risk parity lightened up equity exposure to the tune of some $200-300 billion.
There is a sense in which credit is perhaps more vulnerable than stocks as central banks continue to rollback accommodation. Clearly, tapering, balance sheet rolloff and rate hikes have implications in the credit space, but more to the point, HY has been effectively insulated from idiosyncratic risk by the global hunt for yield. Investors have been chased down the quality ladder and that mad scramble has left everything but the dodgiest of credits priced to perfection.
On the IG side, there’s a duration story at play and as Deutsche Bank’s Aleksandar Kocic detailed in a series of notes earlier this year (see here for some excerpts), “as robustness of the HY had been accepted, IG, at the same time, has become associated with macro-systemic risk .”
Well speaking of IG and macro-systemic risk and also the resiliency of equities, Goldman’s John Marshall, Katherine Fogertey and Rocky Fishman (he was at Deutsche until last year and while there, spent a good bit of time writing about what we variously characterized as the “doom loop“), are out with a new note documenting a discrepancy between IG performance and equities which they believe may spell trouble for the latter.
“Over the past month, US Investment Grade credit has steadily underperformed its corresponding equities, punctuated by a significant credit widening yesterday,” they write, adding that “despite CDX IG 5Y widening 3bps yesterday afternoon to 67bps, there was little SPX reaction and only a modest rise in the VIX.”
They go on to compare the recent divergence to that seen in January a few weeks prior to the February meltdown in stocks. To wit:
We estimate the equities corresponding to the names in the CDX IG Series 30 are up 3.5% in the past month while a risk equivalent investment in CDX IG 5Y is down 2.8% (selling protection at 12x hedge ratio). Relative to volatility over the past year, credit has underperformed equity by 3.1 standard deviations over the past 2, 4, 6 and 8 weeks when compared to these same rolling periods over the past year. This compares to a 2.7 standard deviation dislocation when we last wrote about a similar divergence in January.
Going forward, that doesn’t bode particularly well for equities.
Specifically, Goldman notes that “over the past year, when credit has underperformed equity by an average of 1 standard deviation over a 2, 4, 6 and 8 week period (12% of observations), equity was down an average of -2.3% over the subsequent month.”
They go on to flag a similar phenomenon in Europe (i.e., equities relative to Main), but they see it as different in kind given that European stocks have sold off amid the political turmoil in Italy. The point being that it’s just a matter of who is right in magnitude as opposed to the U.S. where it’s a question of who is right about risk-on vs. risk-off:
While there has been a similar divergence in credit and equity in Europe (exhibit below), the divergence is less notable in our opinion because European equity has traded down on an absolute basis. This suggests European equity investors are already focused on the risk and the debate is about magnitude rather than direction. US equity investors are, in contrast, bidding up stocks despite this growing international concern.
So take that for what it’s worth but you know what they say about who’s usually right when credit and equities disagree…