Forget The Fed, Will A Credit Crash Kill The Stock Market?

• The U.S. credit market has underperformed equities by a wide margin in the past two weeks.
• While this type of sell-off is typically a bad sign for equity markets, it could simply be a regression based on equities’ relative weakness in recent months.
• Goldman Sachs is monitoring the situation closely for any indication of a potential S&P 500 sell-off.

All eyes are on the Federal Reserve this week for signs of the U.S. interest rate policy in 2016 and beyond. However, Goldman Sachs analyst John Marshall has been watching the sell-off in the credit market instead. In a new report, he discusses what this recent drop means for the stock market.

Credit divergence
In the past week, the credit market has been under selling pressure, but equity markets have remained relatively resilient.

“Credit spread widening usually has negative implications or equity, but we believe it is critical to estimate the degree to which the equity market has already priced the weakness to determine the potential risks to equity going forward,” Marshall explains.

High-yield equities foreshadowing credit drop
According to Marshall, the 0.8 percent widening in the CDX HY 5Y is more than explained by the 25 percent decline in their corresponding equities in the past eight months. The graph below shows how much the equity/credit spread had widened before the recent credit regression.



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Cause for concern?
Marshall says that Goldman is monitoring the situation closely to look for signs that the S&P 500 may soon follow the credit market down. Investment–grade equities have outperformed investment-grade credit by 4.0 percent in the past two weeks, and Marshall says that the overvaluation in equity versus credit is “meaningful” for equity investors.

In the past two weeks, the SPDR Barclays Capital High Yield Bnd ETF JNK has fallen 4.0 percent while the iShares IBoxx $ Invest Grade Corp Bd Fd LQD is down 1.5 percent.

Disclosure: the author holds no position in the stocks mentioned.