Buybacks, dividends, and M&A all depend on firms’ abilities to borrow cheap. With leverage ratios rising (and micro fundamentals weakening) as we noted here, macro fundamentals deteriorating, and the visible hand of the Fed now lifting off the repressed neck of risk managers, we have a simple question – What Happens Next? Simply put, your glowing stocks cannot rally in a world of surging debt finance costs.
Remember – and it’s important – there is no rotation that drives high-yield credit spreads wider without punishing equities. They are liabilities on the same capital structure and rise and fall in a highly correlated (well non-linear co-dependence) manner as the underlying business risk rises and falls. Do not, repeat do not, see high yield credit weakness as a sign of rotation to stocks – if the credit cycle has turned then stocks are set to fall. And bear in mind that while HY yields are at all-time lows, spreads are not and in fact being short stocks relative to credit makes more sense if you are you are a bear on the credit cycle here. The only problem being that the epic flows that sustained a credit market at non-economic levels for so long will exit in a hurry.