Corporate credit might be the the pachydermic herd in the room, but it’s a better buy than equities, according to HSBC’s Richard Cookson.
In a note published on Friday, Mr Cookson argues that “it’s unclear why we’d be anything other than underweight equities and overweight credit.”
He argues, emphasis ours:
…corporate debt is just about as cheap as it’s ever been compared with corporate equity. Over the next few years it’s likely to become a lot more expensive, both because spreads fall and because equity valuations fall a lot, much as happened in the late 1930s.
The big problem for now is that dividend yields are under huge pressure from plunging corporate profits and dividends that are being slashed left and right. In the medium term, then, the only way in which relative valuations can improve is if spreads fall a lot or equity prices adjust downward. In English, if corporate spreads don’t collapse, then there’s a big risk that equity prices will collapse even more than the 60% they’ve already fallen.
US equities would look reasonable value compared with investment-grade credit were spreads to fall to 220bps and look cheap were spreads to fall to 150bps. If spreads fall by only 150bps from present levels, nominal growth in GDP is a percentage point less than our strategists assume in their equity-risk premium calculation and dividends are cut by 20% from present levels – none of which seem especially heroic assumption – then the S&P500 would be reasonable value at, er, 200.
Ignoring a tactical bounce, always a possibility, the real question for equity investors is whether they are now paid sufficiently to take equity risk in an environment where the global economy is collapsing faster than one of Navigator’s cheese soufflés (yes, he’s a man of hidden shallows). Probably not, is our answer, unless credit spreads fall an awful lot.
And:
when it comes to relative valuations and likely future performance, corporate debt is, quite simply, hugely more attractive than corporate equity. Even though the latter market has now fallen almost 60% from its high, there’s still a lot of downside risk. Strategically, over the next few years we would strongly expect a huge revaluation of corporate debt compared with corporate equity. That’s likely to mean spreads come in a lot in coming years, as they did in the 1930s after spiking up hugely at first, but there’s a risk, too, that equity valuations will adjust lower via the simple expedient of prices falling further.
You get the picture.
Related links:
Prospects for US high-yield grim, says S&P – FT Alphaville
Extreme corporate credit bulls – FT Alphaville