The corporate bond market is firing a 'warning shot’ for stock investors

  • Widening spreads in the credit market are a warning to equity investors to pay attention to the yield curve inversion, according to Lisa Shalett of Morgan Stanley Wealth Management.
  • The longer the inversion continues, the more likely it is to point to recession out 12 to 14 months according to Morgan Stanley.
  • Visit Markets Insider’s homepage for more stories.

Widening spreads in the credit market, especially with regard to high-yield debt, are a “warning shot now being fired,” according to Lisa Shalett of Morgan Stanley Wealth Management.

The widening of credit spreads comes amid an ongoing debate about how serious the most recent inversion between the 10-year and 3-month US Treasury yield curve is for markets. During the last inversion in March, many argued that the five-day episode was not cause for concern because of strong economic data.

But when the yield curve inverted in March, credit spreads remained tight. In the last few weeks, however, credit spreads have widened out. Investment grade option-adjusted spreads are now the widest they have been this year, up 20 basis points. High yield option-adjusted spreads are up 70 basis points in the same time period.

“The backdrop is much different,” Shalett told Markets Insider. Weak retail sales, durable goods orders and purchasing managers reports have darkened the outlook in the last eight weeks and have the potential to drive negative surprises, she said. “Those as part of a mosaic don’t paint a very positive picture.”

As the inversion nears 12 days, the length has become more worrying. The longer an inversion of the yield curve goes on, the more likely it is to precede a recession. Inversions of more than one month have foreshadowed each of the seven recessions in the last 50 years, according to Shalett, with a lead time of 12 to 14 months.

The market has priced in expectations that the Federal Reserve will cut interest rates by the end of the year. But, the market is ahead of the Fed, and has been for some time, Shalett said.

On Tuesday, Fed Chairman Jerome Powell said the central bank was keeping a close eye on trade tensions and was prepared to take action if necessary, signalling that he’s open to cutting interest rates. Stocks surged on the news.

In addition, corporate earnings, which have driven the bull market, may decline through the year. Morgan Stanley expects a 5% to 7% market correction on the expectation that second-quarter earnings estimates are going to disappoint, Shalett said. That means that more choppiness in stocks is likely ahead and will continue through the summer.

Increased concerns over the trade war between the US and China and new tariffs on Mexican imports don’t help, and could even drag down market performance.

“We’re really ratcheting up to a new level of uncertainty for the markets,” said Shalett. Investors will see “definitely sideways and down markets between now and Labour day.”

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