Stresses in financial markets have eased significantly in the months following the peak of the coronavirus panic in March, but the gains are slowing and key metrics still indicate that market risks are higher than they were before the crisis.
"The easy part of the liquidity-driven rally in credit is over," Rob Robis, chief fixed-income strategist at BCA Research, wrote in a research note. "More gains are to come, but investors will need to be more selective."
With credit markets supported by the Federal Reserve, the U.S. investment-grade spread against Treasurys has reversed almost 90% of the widening experienced during the March panic. However, the path back to pre-crisis levels has stalled, with the spread widening by 2 basis points in the week to Aug. 17, to 136 bps.
"Investment-grade corporate credit spreads no longer offer compelling value in most developed economies, while high-yield spreads are tightening in the face of rising default rates in the U.S. and Europe," Robis wrote. "Investors should consider rotating into credit sectors that still offer some relative value — like emerging market hard currency corporates."
The emerging-market investment-grade corporate spread has been grinding ever downward, shedding 5 bps between Aug. 10 and Aug. 17, to 348 bps. The spread has reversed 74.6% of the coronavirus-induced widening.
The U.S. high-yield spread climbed by 20 bps in the same seven-day period, returning to a three-week high, but U.S. high-yields have reduced 76.4% of their March widening.
Despite the high-yield spread widening, the overall picture is one of investor confidence even amid record-breaking recessions in much of the developed world.
"Markets look expensive if our economists are correct that the global economy will not fully recoup lost output, profits and employment until after 2021, but current growth momentum is too strong in too many countries to hold bearish forecasts or a defensive portfolio [position] now," JPMorgan strategists led by John Normand wrote in a research note.
The bank said it would take a major macroeconomic reversal to stop the trend of rising equity prices and narrowing credit spreads, listing a failure of the U.S. Congress to approve further fiscal stimulus, a ratcheting up of the tariff war with China and post-election policy as the main risks.
Equity markets have also calmed, with the S&P 500 and Nasdaq at record levels. After climbing by the largest daily amount in a month Aug. 11, the volatility index settled down the following week, unwinding 2.52 of that 2.9 increase to close Aug. 18 at 21.51. By contrast, the index averaged 27.0 in July and 31.1 in June.
Other measures of stress also suggested decreasing risk.
In the leveraged loan market, the share of issues priced below 80% — a closely watched indicator suggesting a company is more likely to default — fell below 6.6% on Aug. 17, its lowest level since March 6 but still almost double the 3.4% average for the first two months of the year.
Meanwhile, the Libor-OIS spread, a key indicator of stresses in short-term bank funding markets — measuring the difference between the three-month dollar London interbank offered rate and the overnight indexed swap rate — rose just 0.8 basis point, to 16.2, as of Aug. 17.