Current credit-equity divergence opens opportunity

Looking for potential before the spread narrows

May was an eventful month for markets. Incoming economic data implied that interest rates are likely to stay higher for longer, which weighed on fixed income markets. Large-cap equities were unfazed by higher discount rates and plowed higher, driven by enthusiasm about the potential of artificial intelligence (AI). An increasingly narrow set of market leaders is not healthy for the market, but investor psychology and fear of missing out (FOMO) might continue to drive performance over the short term.

The ICE BofA US High Yield Index put up its worst absolute return since February, returning -0.9%. Option Adjusted Spread (OAS) widened 16 basis points (bps) to finish the month at 469 bps. In contrast to large-cap equities, the high-water mark for the high yield market in 2023 was on February 2. Since that time the price return was -3.9% including carry the market has returned -1.8% with spreads 75 bps wider. It seems unlikely to us that spreads will revisit early February levels in the near term.

Market update

We believe that the divergence between credit and equities, which has been widening since March, will eventually mean revert, as credit conditions are typically a leading indicator of economic activity and asset prices.

Current market dynamics echo divergences that we have seen in past market cycles. In 2007, credit markets peaked approximately four months before large-cap equities and bottomed out in December 2008, roughly three months before equities.

While enthusiasm for AI is justifiable, a well-understood theme with strong retail investor participation has some similarities to the “dot-com” bubble of 1999-2000. We believe that the underlying reasoning behind the theme will be correct just as it was in 2000. While the internet did indeed change the world, valuations were not supported by the cash flows that followed.

We find it hard to square the valuation of mega-cap technology stocks with what we believe is an appropriate discount rate. Looking at month-end prices relative to Bloomberg consensus 2023 calendar year-adjusted EPS estimates, the seven largest components of the Invesco QQQ Trust Series 1 (NSD: QQQ) trade at an average P/E multiple of 36.9x, with expected EPS growth of 25% in 2024, decelerating significantly thereafter.

Sell-side analysts are generally an optimistic group, so it would be rational for markets to discount a slightly less favourable outcome. After all, Apple, Alphabet, Nvidia, Meta, and Amazon all generated negative earnings per share (EPS) growth in 2022. With Tesla expected to report negative earnings growth in 2023, that leaves only Microsoft among the big seven that won’t have a negative earnings growth print in either 2022 or 2023, and that company put up a paltry 3% EPS growth figure in calendar 2022.

While these are mostly great businesses, based on the multiples they trade at, the perception of consistent earnings growth might exceed reality. Ultimately, their customers are individual consumers and businesses that are sensitive to economic cycles, which could cause them to pull back on advertising and discretionary spending, such as luxury vehicle purchases.

While high-multiple equities should be negatively impacted by higher rates, they haven’t been impacted in recent months. In contrast, Canadian rate reset preferred shares should benefit from higher rates, as their coupons reset every five years at a fixed spread over five-year government bond yields. This has not been the case as the market has performed poorly, partially driven by exposures to out of favour sectors like banking and energy infrastructure.

We now believe that some of the most mispriced securities in the market are preferred shares. For example, the coupon for Enbridge Inc. preferred series Y (TSX: ENB.PR.Y) will reset in September 2024. And if the Canada five-year yield is the same rate then as it was at the end of May when the preferred was trading just below $14, the current yield for this security would be over 10% at that price.

We believe that the potential path of interest rates is balanced from here, while the performance of securities like QQQ and BMO Laddered Preferred Share Index ETF (TSX: ZPR) would argue that the market is expecting lower rates over the near term. Market pricing could be reflective of recency bias following almost 15 years of exceptionally easy monetary policy.

If the past year has taught us anything, it is that the economy can handle much higher rates than previously thought, which supports the argument that neutral policy rate estimates should be revised higher by central banks. While there is little evidence of risk aversion in certain pockets of capital markets, weakness in commercial real estate and banking could be leading indicators that may adversely affect the broader economy in the quarters ahead.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Manager’s Commentary, May 2023. Used with permission.

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