Investors Are Getting Nervous About The Quality Of Assets

 |  Includes: DIA, IEF, IWM, QQQ, SPY
by: Evariste Lefeuvre


Many cross asset relationships have broken down recently.

Interestingly they are driven by much more than the single interest rate risk.

Investors are also getting more and more concerned by the underlying quality of several asset classes.

It looks like a bunch of cross asset relationships have broken down recently. I propose a quick overview and try to draw some conclusions.

The first signal comes from stocks and bonds. As can be seen below, the relative return of U.S. stocks to U.S. high yield corporate bonds is no longer tracking the price action of U.S. Treasury yields. The recent outperformance of U.S. Stocks is not "consistent" with the fall in U.S. yields. The correlation break might be temporary but the question pertains to who would be steering the mean reversion.

The message is unclear. I would not draw from this that high yield bonds are attractive. The tightness of spreads coupled with the forthcoming end of tapering is clearly negative for this asset class. The underperformance of high yield against leveraged loans is in that sense not really convincing since, in an environment of falling yields, leveraged loans should have underperformed. On the contrary, the current 1-month return of the S&P 500 cannot justify alone the 5% underperformance of U.S. high yield against investment grade.

There might be something more than just yields here: perhaps a "quality risk." The chart below shows that while the Equity Risk Premium remains slightly above its medium run average, the high yield spread against U.S. Treasuries is close to historical lows (same conclusion when it comes to the differential between both risk premia).

This quality risk premium can also be observed when one looks at the small vs. big return spread compared to that of investment grade to high yield. There is some consistency in the relative behavior of both spreads whose correlation is generally positive, except during sharp external shocks.

Interestingly enough, the stock/bond relationship is back to normal (that is higher yields = higher stock prices) and does not show any mispricing. I would expect this trend to continue with yields ramping up when the fed stops tapering and stock prices continuing to edge up as well.

Bottom line: The end of QE is clearly about under-weighing high yield bonds and small stocks. Value should also outperform in such a context, as the chart below shows. The main risk factor is clearly higher U.S. Treasury yields and liquidity. But the behavior of some cross asset relationships suggests that some investors are beginning to be wary about the underlying quality of some asset classes, a top of directionality risk.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.