(Bloomberg) -- Just a few days after policy makers helped restore confidence in the global banking industry, a semblance of calm has returned to Wall Street.
Yet with a Federal Reserve decision on interest rates looming, the companies that are the most exposed to rising borrowing costs are being shunned in the underbelly of the stock market.
As traders grapple with tightening credit, a Bloomberg index that goes long highly leveraged stocks and shorts those with limited debt just posted its worst week since April 2020. It’s a similar story based on Goldman Sachs Group’s baskets. Among US small-cap shares, a Societe Generale SA index buying equities with strong balance sheets and selling the opposite rose for 10 straight days through Monday, the longest streak since 2018.
While the market rout last week was exceptional on the heels of the crisis hitting Credit Suisse Group AG and regional US banks, the fear is that lenders are set to turn more cautious. That suggests the weakest links in Corporate America will face a rough ride — ramping up recession risk — while the likes of Citigroup Inc. strategists say a credit crunch is now inevitable.
“Its severity depends on how much additional support there is to come from US authorities and how quickly confidence can be re-established,” the Citi team led by Dirk Willer wrote in a note. “With equities having barely reacted to the turmoil, after rallying strongly from last year’s lows on a soft-landing narrative, we see downside for risky assets.”
As the bank drama has unfolded in March, investors rushed to safety and Treasury yields plunged. But the extra premium paid by corporate bond issuers is set for the biggest monthly jump since June.
That’s why fund managers polled by Bank of America Corp. this month picked a systemic credit event as the biggest tail risk. Meanwhile the co-head of research at JPMorgan Chase & Co. has flagged the potential for a “Minsky” moment — a sudden, dramatic collapse of assets marking a big turn in the business cycle.
To some extent, that may be hyperbole, and for now fading stress in the financial industry is supporting markets. The S&P 500 is still up nearly 1% this month through Tuesday, helped by gains in tech giants that are getting a lift from easing Treasury yields.
But elsewhere, strategists are taking cues from widening spreads on corporate bonds and credit default swaps. At Societe Generale, quants led by Andrew Lapthorne slice and dice stocks by a variety of factors, or characteristics that drive their returns. So far this month, one that sorts Russell 2000 stocks — excluding financials — by their probability of default based on a Merton model has posted the biggest moves out of 20 they track as of Monday.
To Lapthorne, the volatility is a sign that smaller firms are the most at risk from credit tightening. At the end of 2022, the earnings before interests and taxes of Russell 2000 names were just about three times their interest costs, compared with 14 times for the 150 largest US stocks.
The profit estimates of these smaller companies are also falling more quickly, and they will face an increasing amount of debt coming due each year until a 2026 peak, according to SocGen’s research.
“When you get a tightening cycle, balance sheet risk builds and builds and builds until something breaks,” Lapthorne said in a phone interview. “The real issue for balance sheet is when profits start declining and cash flows start declining, and we’re not there yet.”
©2023 Bloomberg L.P.
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