I’ve spent a lot of time here and on social media drawing attention to the waning risk appetites in junk bonds and leveraged loans. What I haven’t done is fully explain why I think it’s so important to pay attention to. In short, all of the markets, whether you’re talking about stocks, bonds, commodities or currencies, are all interrelated and cyclical. What’s happening in the commodity markets has implications for currencies and vice versa. What’s happening in the bond market has implications for stocks and so on and so forth. Right now it looks to me, from the action in many of these markets, like the overall upcycle could be close to peaking and rolling over.
Why do I focus so intently on risk appetites? Because risk appetites are the main driver of the overall cycle. When investors are eager to take on more risk, riskier companies are more able to finance their endeavors. When investors become risk averse, it becomes harder for these companies to finance and those who overextended themselves during the upcycle face the prospect of failure during the downcycle.
This is why the Fed has made it perfectly clear that one of the goals, if not the main goal, of quantitative easing was to stoke risk appetites because this provides a boost to the credit markets. Hopefully companies use the easier credit to spend, invest and otherwise stimulate the economy. (In the current cycle, a lot of that money went to things like stock buybacks, though, so the direct impact on the economy wasn’t as great as the Fed probably hoped).
So the fact that risk appetites for high-yield bonds and leveraged loans are waning so rapidly should be a worrisome sign for all kinds of investors because it means the main driver of the cycle is now waning. Now consider the crash in the price of oil and other commodity weakness which is a deflationary sign. And also consider the surge in the dollar, or crash in foreign currencies depending on your geography, which could cause all kinds of problems for the folks who borrowed too much money in dollar terms. And finally consider the plunge in sovereign bond yields, including treasuries, in developed nations around the globe, a clear sign that not only inflation but future economic activity, here and abroad, may not be as robust as we thought a few months ago.
All of these signs are flashing red for both the economy and the markets, in my humble opinion. And at the very least, the drying up of liquidity in the high-yield and leveraged loan markets will have a negative impact, and possibly a very large one, on mergers & acquisitions, LBOs and buybacks, three significant sources of demand for equities. All in all, it looks to me like the boom in risk appetites which has driven the markets higher over the past five years could be in the process of reversing and the major implication for the markets is not bullish.
Bloomberg: Carl Icahn Calls Junk Bonds A Bubble
Dr. Ed Yardeni: The Energy Bubble