The sharp sell-off in the US HY has focused investor attention on risk and financial leverage in
equities. We look at the drivers of the US credit market and the implications for equities. In US
equites, our strategists have a clear preference for strong balance sheet companies versus weak
balance sheet names (GSTHHBAL vs. GSTHWBAL). In Europe, we believe financially levered stocks
(GSSTFNLV) are generally less vulnerable due to a combination of their lower exposure to
commodities and more policy support.
Credit spreads have widened to recessionary levels...
Among the many risks investors are focused on currently is the sharp
widening of credit spreads, particularly US HY. The widening is concerning
as, on our analysis, credit spreads have reached levels that are consistent
with a global recession.
...but this has been largely related to commodity exposure...
That said, our credit strategists note that, while spreads at current levels
gave advance warning of recessions in 1990 and 2001, in 2008 spreads did
not reach current levels until after the recession had begun, and in 2011 were
a false signal. Most economic data suggest US recession risk is low and we
expect spreads to tighten again in 2016. Second, our credit strategists argue
that much of this widening relates to the heavy weight of oils in the (HY US)
index. Metals & Mining and Energy sectors account for 32% of the market.
They continue to prefer IG to HY in the US, and Europe to US IG.
...and liquidity issues
There are also significant liquidity concerns. There have recently been
record volumes in HY ETFs and imposed limits to volumes exacerbate
these concerns. Last week, $3.5 bn exited HY funds in the US, $2.8 bn of
which was from mutual funds.
What about equities?
One concern is that problems in HY credit have yet to be fully reflected in
equity. HY credit spreads have increased much more than implied volatility
for the S&P 500. Also, highly levered US companies have not sharply
underperformed despite the poor performance of credit. Our US equity
strategists recommend a long in strong balance sheet stocks (GSTHSBAL)
vs. weak (GSTHWBAL). We believe financially levered European stocks
(GSSTFNLV) are less sensitive (outside those exposed to commodities) to
the US HY sell off. That said, risks in credit make us reluctant to recommend
these names; we prefer our high DY with growth basket (GSSTHIDY), this is
screened on balance sheet criteria, to ensure the dividend is sustainable.