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Junk Bonds Flashing Warning Signs

3 best leading indicators for recession have been Credit Spreads, the Shape of the Yield Curve and Profit Margins.

US High Yield credit spreads have widened since Jun 2014 and the widening spread is not only due to the energy sector.  The big picture is that the US credit market has turned the corner and investors in high yield bonds are expecting to see their first negative return since the start of the credit crisis in 2008.

In the past, the strength in credit is seen to be the big supports for equities.  The rollover in high-yield credit is not a good sign for equity as the two don't tend to diverge for too long.  When credit spreads widen, equity markets endure volatility.

High Yield spreads excluding energy accounts for about one third of the high yield market.  The chart below shows that US High Yield (ex Energy) have been diverging from the S&P 500 throughout 2015.

The chart below shows that widening credit spreads have been the bellwether of previous recessions.

From the chart above, we observe that the high yield started to plunge towards end of 1997 or beginning of 1998, however, the S&P continued its rally until early 2000.  The divergent between the two lasted about 2 to 2.5 year.  The similar pattern is now observed.  There are good reasons to believe that the divergent between the two will continue as next November 2016 is US Presidential Election.  Nonetheless, this would probably be the last rally before the real correction kicks in.  Between now till November 2016, we would not rule out the probability of pockets of correction.

At the moment, we have to be very cautious in what to invest in as we are in a situation where equities valuation, in particular US might not be cheap.  On the other hand, bond is not cheap as well as the expectation of interest rate hike in 2015-12-17 is real.  When US hike its interest rate, we might see some emerging markets to suffer further losses...what about other markets?  History tells us that if US market were to be on downward trend, the rest of the world would likely to follow.


MarketWatch, Ellie Ismailidou & Anora Mahmudova, 2015-12-07, "Deteriorating Junk Bonds Flash Warning Signs For Stocks"