The Nasdaq index dropped over 3 percent last Friday even though there was no major negative news that day. Such slide is evidence that what’s really hurting the market is a tightening liquidity environment.
To gauge market liquidity, the credit spread between US Treasuries and junk bonds gives a fairly indicative picture.
Credit spread measures the extra borrowing costs companies have to pay above the risk free rate, or that of US Treasury bonds.
This spread typically tightens when economic growth is picking up, but widens when economic condition deteriorates.
Historical data shows when the spread is narrowing, stock market usually performs well. When the spread is tightening, stock market generally underperforms.
This is not difficult to understand, considering stock prices are mainly determined by two things: corporate earnings and stock valuations.
Previously, when three quantitative easing (QE) programs had injected massive liquidity into the market, the action helped cut the financing costs for most companies, of both good and bad quality, and hence lifted their earnings.
When liquidity is ample, investors tend to accept lower returns on investment. In other words, they would accept higher price-earnings multiples. Higher stock valuations thus became the norm.
That’s why we have seen the stock market on an upward trajectory, until the recent setback.
US equities have seemingly peaked at the end of September, which coincided with the timing when the credit spread between 10-year US Treasury and junk bonds bottomed.
Instead of QE, the Fed has been doing the reverse now, as it continues with so-called quantitative tightening (QT), meaning not rolling over the bonds when they mature. In this situation, borrowers, especially those with weak credit, have to pay market rate for funds.
Rising funding costs will eat into profits. Higher cost of money also means companies have to be a lot more selective in investing in new projects. These combine to hit profitability.
On the investor side, the tighter liquidity environment means they would demand a higher return to justify the higher cost of money.
How far will the spread go?
I believe there is a chance for the yield differential between 10-year Treasury and junk bonds to widen to 8 percent, a level seen during the 2011 Eurodebt crisis, and when oil prices tumbled to US$25 a barrel in early 2016.
When will the Fed stop its QT? My guess is 6-12 months before the next presidential election in 2020, or if there is crash of the Nasdaq to below 5,000 points. When that happens, it would be great timing for long-term investors to buy shares.
This article appeared in the Hong Kong Economic Journal on Dec 12
Translation by Julie Zhu
[Chinese version 中文版]
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