Credit Fears Quashed as Fragile Stocks Win by Most Since 2006
(Bloomberg) -- Wall Street bears who say fragile companies will be killed off in the era of rising rates, take note: Heavily indebted U.S. stocks are outperforming their stronger counterparts by the most in at least 16 years -- just as yields break out.
That’s even as credit investors ease up their exposures to the riskiest firms in the new year bond rout that’s been spurred by hawkish signals from the Federal Reserve. Stock managers are wagering that the weaker corporates -- which now face higher borrowing costs -- are set to gain from growing risk appetite and corporate earnings thanks to the economic expansion.
Another way of thinking about it: The outperformance of large-cap firms with the weakest balance sheets in Goldman Sachs Group Inc. data suggests the stock rotation has legs in favor of firms tied to the business cycle.
“Real rates tend to go up in a very strong economy,” said Dennis Debusschere, founder of 22V Research. “The ‘leverage factor’ tends to have more of those names that benefit from higher rates and a strong economy.”
While the S&P 500 lost nearly 2% last week as bond yields surged, the moves have been accompanied by optimism the omicron variant will not derail the economic recovery, with studies showing it causes less severe symptoms.
That has helped drive funds toward companies most-hitched to the business cycle, with riskier sectors like energy and financials topping U.S. large-caps.
The question now is how far rates will climb. Treasury yields were rising for a seventh straight day on Monday morning in New York, at one point reaching a two-year high. Goldman strategists boosted their rate hike projection to four increases this year instead of three.
Against that backdrop, Monday looked set to be another rotation-heavy session, with the rush out of pricey tech names outpacing other areas of the stock market. Futures for the Nasdaq 100 led the drop as contracts for the three main U.S. equity gauges all retreated.
Goldman’s baskets sort S&P 500 stocks by the Altman Z-score, which measures the likelihood of bankruptcy. By that metric, some of the riskiest large-cap firms include Carnival Corp., Delta Air Lines Inc. and energy producers like Occidental Petroleum Corp.
Quant’s Eye View
In equity characteristics tracked by quant traders, a leverage factor built by Bloomberg that takes out the biases of market direction, sectors and other factors boasted its best week since October last week.
Meanwhile, the quality trade that goes long profitable and low-leverage shares and short the opposite plunged the most in 11 months. A value strategy -- which buys cheap, typically riskier shares -- was up most since November 2020, when Covid vaccines were first announced, a S&P Global index shows.
Now with bond yields jumping, the risk is growing that the Fed’s resolve to tighten financial conditions will eventually undercut growth.
“If you believe that this year is going to be all about central bank tightening, value seems like a good way to hedge off that bond risk,” said Andrew Lapthorne, global head of quantitative strategy at Societe Generale. “At the same time tightening usually brings about other risks, such as leverage problems, so I would prefer the inflation-related value plays over just buying junk.”
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