Credit Cracks Spur Historic Moves in Systematic Stock Trades

(Bloomberg) -- As U.S. stocks slump anew and recession angst snowballs, defense is now the only game in town.

Equity investors are punishing the weakest companies and rewarding the strongest as earnings expectations plunge thanks to the coronavirus outbreak, while exposing shaky foundations of credit markets.

That’s all driving historic moves across systematic-investing strategies.

A long-short trade that bets on firms with the highest leverage is set for its worst week since 2008 after its worst day on record on Tuesday. One that buys the most profitable names has gone parabolic. Another that wagers on the most volatile stocks has plummeted to the lowest in more than a decade.

With liquidity draining from the credit market, anxiety is running high about how the most indebted companies will refinance at higher borrowing costs. Meanwhile, record equity volatility is putting a premium on those with safer balance sheets.

That’s pushed a throng of investors into expensive companies with low debt, reliable profits and -- relatively -- stable price moves.

The S&P 500 fell more than 7% in Wednesday trading, triggering a 15-minute pause, sending U.S. stocks down to levels in December 2018.

As policy makers struggle to ease the rout with monetary and fiscal stimulus, few investors are venturing out of increasingly crowded havens.

“While that policy response is still being formulated, we think that credit spreads have the scope to go wider,” Sanford C. Bernstein strategists led by Inigo Fraser Jenkins wrote in a note. “Good balance sheet quality companies have been relatively re-rated for sure but are not at such extremes.”

For many sectors, the economic pain is just starting. Shutdowns in the U.S. and Europe to combat the virus are disrupting businesses, interrupting their payments to suppliers, threatening more defaults, credit downgrades and fund outflows.

From that perspective, the swift sell-off in risk assets is largely justified, according to Matt King, global head of credit strategy at Citigroup Inc.

“Rising credit problems would drive equity valuations lower still,” he wrote in a note. “The risk that missed payments start to create a cascade of credit defaults seems quite high. At the very least, the likelihood of companies and countries coming out of this with a great deal more debt than they went into it has gone up. Investors are already responding to this very rationally.”

An extraordinary market rout is testing one view held on Wall Street last year that already-expensive safe havens would struggle to live up to their label when the next crisis hits.

But in this 2020 crash, the most crowded stocks -- such as low-volatility names -- have outperformed in the market and may continue to “with no nadir to this crisis in sight,” Citi strategists including Hong Li wrote in a note.

Even on Monday, when the S&P 500 rallied 6% and bonds slid on America’s stimulus proposal, minimum-volatility stocks -- which typically overlap with bond proxies -- surged to the highest since 2016 versus the overall market, according to MSCI indexes.

Meanwhile, a factor that bets on firms with the highest profit margins has posted a 4.7% gain over the 10 trading days to Tuesday, the highest since 2001, as investors herd into the strongest names.

“Already before the virus outbreak the quality of non-financial corporate credit was low compared to history,” the Bernstein strategists wrote. “As growth slows suddenly we think this will cause a further move up in credit spreads. We don’t think this is fully priced in the equity market.”

©2020 Bloomberg L.P.