Credit leads equities. Despite their ominous start in 2016, U.S. stocks might have much more room to move to the downside in the coming weeks and months based upon several indications in the credit markets, which are rapidly deteriorating.
Corporate and municipal debt issuance waning
New corporate debt issuance has been in negative territory since September, 2015 according to data released this week by the Securities Industry Financial and Financial Markets Association (SIFMA). More alarming is the fact that December was the worst month in 2015 for new municipal debt issuance, meaning the credit crisis has affected the ability of state and local governments to fund their operations.
Monday, Puerto Rico skipped $37 million in bond payments. The move was challenged in U.S. Federal court Thursday by two bond insurers, sparking renewed controversy over the island territory's ability to make preferential payments to certain creditors. One of the plaintiffs, Ambac Financial Group Inc., was front and center in the run-up to the financial crisis of 2008.
As Mark Twain famously quipped, "History does not repeat itself, but it rhymes."
Separately, the state of Alaska is considering a personal income tax for the first time in 35 years. Alaska, which is largely funded by crude oil revenues, has suffered decreases in tax revenue concurrent with the decline in the price of oil, which has plunged from $103 per barrel in June, 2014 to nearly $32 per barrel Thursday Smaller oil drillers must tap the high yield debt market to fund their capital intensive operations, and many are not profitable when crude is under $65 per barrel.
When market turmoil erupts, correlations tend to converge on one or negative one, meaning everything goes up or down in lockstep. Currently, the fallout from the drop in the price of oil has roiled credit markets across the world, making it more expensive for corporations and governments to fund their operations. The panic in China has not helped.
According to data from Bank of America Merrill Lynch, the yield on corporate junk debt rated CCC or below has more than doubled since mid-2014, climbing to 18.4% in early January, 2016. The last time this level was reached was just after the Lehman Brothers bankruptcy in September, 2008 when yields eventually soared to just above 45%.
Corporate bond issuance in September, 2015 plummeted to a nadir of -$54 billion, year over year, following the prior crisis in China last year, according to SIFMA. Since then, issuance has remained largely negative, also indicating lingering problems in credit markets.
Mutual fund exodus
Not only are corporations issuing less debt, but mutual funds that invest in that debt are also experiencing record outflows. According to Lipper, for the week ended January 6, 2016, funds reported -$3.1 billion in redemptions. The phenomenon is not limited to the high yield sector, which comprised -$809 million of the total. Funds that hold investment grade debt suffered greater outflows of -$1.1 billion.
This is particularly relevant for equities amidst the backdrop of the Federal Reserve raising interest rates in 2016. If the market for corporate debt dries up and companies cannot raise funds at reasonable yields, they must issue more stock, which exerts downward pressure on stock indices, such as the Dow Industrial and S&P 500 indices.
When taken together, fund outflows and the decline in new issuance of debt paint a worrisome picture for investors in risk markets. While it remains to be seen whether or not the current market downturn will devolve into a full-scale bear market, investors are facing fewer choices in both equities and fixed income. As the CEO of Volvo, Pehr G. Gyllenhammar, famously said after the stock market crash of 1987, "Cash is king."