The Low Spark of High Yield Boys, Redux
High yield is approaching levels where the principal protection risk/reward has been maximized.
The percentage you're paying is too high priced
while you're living beyond all your means.
And the man in the suit has just bought a new car
from the profit he's made on your dreams.
But today you just swear that the man was shot dead
by a gun that didn't make any noise.
But it wasn't the bullet that laid him to rest
was the low spark of high-heeled boys.
The Low Spark of High-Heeled Boys
-- Jim Capaldi and Steve Winwood, Traffic
Amid all the euphoria this week as US stocks broke out to new highs on weaker than expected economic data, the real story for me was the continued performance in the high yield credit market. The markit North American HY CDX Index closed at a new all-time high right alongside the S&P 500 (INDEXSP:.INX) pushing its implied spread to 352bps, a level not seen since 2007.
With little growth in earnings or revenues, the robust rally in equities has been a function of multiple expansion which is directly attributable to the massive tightening of high yield credit spreads. Contrary to previous cycles of spread tightening, this is occurring as yields on Treasuries also fall, suggesting this rally in risk is predicated not on what many assume in QE reflating assets, but rather the exact opposite in lower inflation premiums.
When the Fed balked at extending QE II when it was due to expire at the end of June 2011, it was a rude awakening for speculators who were very long an asset reflation correlation trade. However the Fed was in a box because it was this reflation of assets at the expense of the US dollar that was a drag on the consumer. In July 2011 the producer price inflation (PPI) was growing at a whopping 7.0% YoY rate with consumer prices (CPI) growing 3.5% in an economy that was only growing at about 4.0% nominally. In September, with stocks crashing alongside the QE reflation trade, the Fed needed to get back involved. They were well aware of the inflation pressures QE placed on the consumer, so instead of further balance sheet expansion, they opted for the balance-sheet-neutral Operation Twist. This is an important distinction.
You often hear equity strategists discuss valuation, citing the equity risk premium, which is the earnings yield (the inverse of the P/E ratio) measured as spread over the 10-year Treasury yield. The current equity risk premium of 4.6% remains on the cheap side of historical multiples however I think this relative value analysis is inherently flawed because multiples tend to be more sensitive to inflation rather than nominal interest rates.
“Real” Equity Risk Premium
I charted the difference between the S&P 500 earnings yield spread less the 10-year yield vs. the YoY growth in CPI. What you can see is that routinely the earnings yield would trade through the 10-year yield whereas rarely would it drop below inflation. In fact each major top in stocks over the past 30 years (1987, 2000, and 2007) were when the earnings yield met the inflation rate. This is completely rational because the market should only pay a multiple for real returns otherwise the monetary authority could always make risk assets look attractive by manufacturing nominal growth and negative interest rates.
Equity and credit risk premiums are closely correlated, and when plotted together you can get a sense of the risk curve. From the investor perspective, equity risk should always be cheaper than credit risk for where it sits in the capital structure, but in general, equity risk and high yield credit risk premiums have historically been priced at similar levels. High yield investors price credit risk to achieve an “equity-like” return while equity investors price earnings to provide a similar yield that also owns the option on earnings growth.