Global stock markets continued to sell off throughout the week. In the U.S. the S&P 500 closed the week down 142.58 points, although stocks finished the week with a strong rally into the weekend. As my colleague, Chuck Lieberman, mentioned last week, corrections are quite common in the stock market and current economic fundamentals remain strong.

While the volatile moves in the equity markets and failed financial products like the XIV (inverse S&P 500 Volatility Index ETN) do nothing to keep investors sleeping soundly, it is important to note that much of the recent moves are due to technical market distortions caused by these products, rather than purely fundamental concerns. Taking a broader look at other asset classes like the corporate bond market, concerned equity investors may take solace that the wild swings in equity markets have not migrated to other risky asset classes like junk bonds.
From my seat as an investor in U.S. corporate debt across the quality spectrum, I was slightly puzzled by the large moves in the equity markets. Corporate credit spreads have behaved reasonably well despite the recent bout of equity volatility. Investment Grade credit spreads have widened by approximately 7 bps and remain near their lowest levels on record, signaling that blue chip corporate borrowers will be able to continue to borrow in the unsecured debt market without much difficulty. Furthermore, high yield spreads have widened slightly but remain well below levels that would signal market distress. HYG (a popular ETF vehicle used to access the broad U.S. high yield market) declined approximately 2.9% over the past two weeks. While this is a noteworthy move lower, the tone in the market has not been nearly as frantic and confusing as the moves in equity markets. The decline in high yield debt has been rather orderly and provides a worthy counterpoint to the sometimes inexplicable intraday price moves witnessed recently in stocks as equities and corporate bonds are dependent on some of the same core economic factors: corporate profits, economic growth, and interest rates.

 
In recent history, large negative moves in the equity market and increased levels for the volatility index (VIX) are typically accompanied with large price declines for the debt of risky corporate borrowers (wider credit risk spreads). For example, in late 2015 and early 2016, a cautious outlook for the U.S. economy created large price swings for the high yield market and pushed spreads in the high yield market over 400 bps wider. This move was shared by equities, driving the VIX markedly higher, as many market participants wrongly anticipated a looming recession in the middle of 2016. That was not the case this past week. High yield spreads have widened marginally by 30 bps over the past week, as judged by the BofA Merrill Lynch US High Yield Index, while the VIX has rocketed higher. The average high yield spread is now 3.59% instead of 3.29% a week ago. The chart displays that the historical relationship between the CBOE S&P 500 3 Month Volatility Index (right side) and high yield risk spreads (left side) are correlated. However, in recent weeks while high yield spreads have barely budged, the VIX has spiked from around 11 to over 30. Either high yield investors have been asleep for the past two weeks or there is a different factor at play within the equity markets that is driving recent declines.

One potential explanation for the recent stock swoon cited by the news media in the past week is the VIX, itself. The VIX is not an asset but instead a measurement of prospective risk of an underlying asset class (large U.S. equities). There are no underlying cash flows associated with the VIX, just measured expectations of implied near-term equity volatility as calculated by options pricing models for S&P 500 equity derivatives. However, the wonders of financial wizardry allow for volatility to become an investable “asset” through Exchange Traded Notes (ETNs). Investors are now able to express views on market volatility (either more volatility or less volatility) with the same ease as buying a large listed U.S. corporation. With the advent of these easy to trade ETNs and ETFs, real dollars are allocated to seek out and exploit market inefficiencies, and most crucially, speculate on market moves. This speculation has likely exacerbated the wild swings in U.S. stocks recently, as new fundamental factors are being digested by the market and has led to a massive rebalancing of the views of speculators within these products. As the short volatility trade has been viciously unwound in recent weeks, it may have created pockets of forced selling from traders covering losses on their volatility trades and by algorithms that use spikes in the VIX as a signal to sell underlying equities. It is important to parse out the impact of this technical factor potentially impacting stock prices and the fundamental factors at play that will influence the long-term value of stocks.

 
Financial markets are rightfully concerned about the potential for the potential return of higher levels of inflation and an associated increase in interest rates. The ten-year treasury has broken out to new levels not seen since 2013. New macroeconomic risks associated with shifting fiscal and monetary policy are important factors in the valuation of all securities. Higher risk-free government rates lead to higher discount rates in equity valuation models, and also naturally lead to declines in prices for bonds. However, the recent moves in stock prices appear exaggerated in comparison to the reaction of corporate bond markets. Credit markets can act as an important barometer to inform equity investors of the severity of macroeconomic risks inherent in markets and broader investor sentiment. The recent mild moves in the credit risk spreads should give equity investors confused by the recent market volatility pause before making any rash decisions. Even though the recent declines in stock prices aren’t comforting for investors, the rapid decline in the market isn’t abnormal.

Global stock markets continued to sell off throughout the week. In the U.S. the S&P 500 closed the week down 142.58 points, although stocks finished the week with a strong rally into the weekend. As my colleague, Chuck Lieberman, mentioned last week, corrections are quite common in the stock market and current economic fundamentals remain strong.

While the volatile moves in the equity markets and failed financial products like the XIV (inverse S&P 500 Volatility Index ETN) do nothing to keep investors sleeping soundly, it is important to note that much of the recent moves are due to technical market distortions caused by these products, rather than purely fundamental concerns. Taking a broader look at other asset classes like the corporate bond market, concerned equity investors may take solace that the wild swings in equity markets have not migrated to other risky asset classes like junk bonds.
From my seat as an investor in U.S. corporate debt across the quality spectrum, I was slightly puzzled by the large moves in the equity markets. Corporate credit spreads have behaved reasonably well despite the recent bout of equity volatility. Investment Grade credit spreads have widened by approximately 7 bps and remain near their lowest levels on record, signaling that blue chip corporate borrowers will be able to continue to borrow in the unsecured debt market without much difficulty. Furthermore, high yield spreads have widened slightly but remain well below levels that would signal market distress. HYG (a popular ETF vehicle used to access the broad U.S. high yield market) declined approximately 2.9% over the past two weeks. While this is a noteworthy move lower, the tone in the market has not been nearly as frantic and confusing as the moves in equity markets. The decline in high yield debt has been rather orderly and provides a worthy counterpoint to the sometimes inexplicable intraday price moves witnessed recently in stocks as equities and corporate bonds are dependent on some of the same core economic factors: corporate profits, economic growth, and interest rates.

 
In recent history, large negative moves in the equity market and increased levels for the volatility index (VIX) are typically accompanied with large price declines for the debt of risky corporate borrowers (wider credit risk spreads). For example, in late 2015 and early 2016, a cautious outlook for the U.S. economy created large price swings for the high yield market and pushed spreads in the high yield market over 400 bps wider. This move was shared by equities, driving the VIX markedly higher, as many market participants wrongly anticipated a looming recession in the middle of 2016. That was not the case this past week. High yield spreads have widened marginally by 30 bps over the past week, as judged by the BofA Merrill Lynch US High Yield Index, while the VIX has rocketed higher. The average high yield spread is now 3.59% instead of 3.29% a week ago. The chart displays that the historical relationship between the CBOE S&P 500 3 Month Volatility Index (right side) and high yield risk spreads (left side) are correlated. However, in recent weeks while high yield spreads have barely budged, the VIX has spiked from around 11 to over 30. Either high yield investors have been asleep for the past two weeks or there is a different factor at play within the equity markets that is driving recent declines.

One potential explanation for the recent stock swoon cited by the news media in the past week is the VIX, itself. The VIX is not an asset but instead a measurement of prospective risk of an underlying asset class (large U.S. equities). There are no underlying cash flows associated with the VIX, just measured expectations of implied near-term equity volatility as calculated by options pricing models for S&P 500 equity derivatives. However, the wonders of financial wizardry allow for volatility to become an investable “asset” through Exchange Traded Notes (ETNs). Investors are now able to express views on market volatility (either more volatility or less volatility) with the same ease as buying a large listed U.S. corporation. With the advent of these easy to trade ETNs and ETFs, real dollars are allocated to seek out and exploit market inefficiencies, and most crucially, speculate on market moves. This speculation has likely exacerbated the wild swings in U.S. stocks recently, as new fundamental factors are being digested by the market and has led to a massive rebalancing of the views of speculators within these products. As the short volatility trade has been viciously unwound in recent weeks, it may have created pockets of forced selling from traders covering losses on their volatility trades and by algorithms that use spikes in the VIX as a signal to sell underlying equities. It is important to parse out the impact of this technical factor potentially impacting stock prices and the fundamental factors at play that will influence the long-term value of stocks.

 
Financial markets are rightfully concerned about the potential for the potential return of higher levels of inflation and an associated increase in interest rates. The ten-year treasury has broken out to new levels not seen since 2013. New macroeconomic risks associated with shifting fiscal and monetary policy are important factors in the valuation of all securities. Higher risk-free government rates lead to higher discount rates in equity valuation models, and also naturally lead to declines in prices for bonds. However, the recent moves in stock prices appear exaggerated in comparison to the reaction of corporate bond markets. Credit markets can act as an important barometer to inform equity investors of the severity of macroeconomic risks inherent in markets and broader investor sentiment. The recent mild moves in the credit risk spreads should give equity investors confused by the recent market volatility pause before making any rash decisions. Even though the recent declines in stock prices aren’t comforting for investors, the rapid decline in the market isn’t abnormal.

About the Author

Stephen Zurilla

Stephen Zurilla

Mr. Zurilla is a Portfolio Manager of Fixed Income and a member of the Investment Committee. Prior to his current role, Mr. Zurilla has served as a Research Analyst and Trader at ACM. As an analyst, Mr. Zurilla covered fixed...
About the Author

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