Moodys:
Overvalued Equities Threaten Credit Outlook
Equity market overvaluation can be contagious. The more inflated share prices narrow corporate credit spreads, the greater the risk of a sudden, sizable widening of spreads Of late the market value of US common stock is setting new record highs, notwithstanding the likelihood of a second straight annual decline by 2016’s broadest measure of pretax operating profits.
As derived from the Blue Chip consensus forecast of early August 2016, profits will not at least match 2014’s apex until 2018 on a calendar-year basis. Nevertheless, a slow recovery by profits does not rule out new highs for US equities provided that (i) benchmark interest rates remain extraordinarily low and (ii) corporate bond yield spreads do not swell.
Of critical importance to the latter are expectations of not only a limited climb by the US high-yield default rate from July 2016’s 5.5% to a January 2017 peak of 6.5%, but of a subsequent slide to 5% by next summer.
If, however, the default outlook worsens, corporate bond yield spreads will widen and share prices will slump noticeably. Equity market performance matters greatly to corporate bonds, especially those rated less than highgrade. The strong performance by US equities since early 2016 has facilitated a notable stabilization of many high-yield credits and has helped to trigger credit rating upgrades.
Regarding the latter, the high-yield credit ratings of seven issuers from the hard-hit oil & gas industry have been upgraded thus far in the third quarter because of infusions of common equity capital, mergers, or asset divestments.
These financially-driven upgrades received considerable support from a firmer equity market regardless of whether market valuations are fundamentally sound. Nevertheless, the most overpriced equity market since 2002 preserves the possibility of a disruptive correction by share prices that could swell high-yield spreads and diminish high-yield liquidity.
