The Stock Market’s Biggest Risk Is Harder to See Than an AI Bubble

The credit market is an important risk factor for the stocks.. (Spencer Platt/Getty Images)

Key Points

• Citi analysts observe a growing disparity between equity-implied and actual credit market risk premiums. The gap expanded in early November.
• The gap between yields on lower-rated corporate bonds relative to government debt is 2.96 percentage points, 15 basis points wider than late October.
• The equity market’s price momentum relies on benign credit market risks, making stocks vulnerable to significant credit events.

Listen closely. Financial markets may be whispering a warning.

While U.S. stocks continued their November rebound Wednesday, appearing poised to ride strong third-quarter corporate profits and optimism over the federal government shutdown into the end of the year, Citi analysts see a mixed picture.

They note that concern over high valuations and inflation is limiting the gains the September-quarter results might have been expected to yield. And they see reason for concern in how investors in equities and the credit market are assessing the risks.

The analysts, led by Richard Schlatter, see an increasing gap between the risk premiums implied by equities and those in the credit markets. It expanded again over the first week of November as fixed-income investors have become more cautious.

An equity-implied credit spread is calculated from a host of data from other markets, such as derivatives and interest rates, which is then applied to stocks to determine credit risk. It should rise and fall largely in tandem with risk premiums in the actual credit market.

The recent widening of the differential between the two metrics contrasts with narrowing gaps between the risks implied by other important macroeconomic guideposts, such as yields on 10-year Treasury notes, global oil prices, and the performance of the U.S. dollar. And it could suggest a headwind for stocks over the final weeks of the year and beyond.

“The equity market remains complacent of credit risk as the gap between implied and actual credit spreads has widened again [and] is mostly in sync with the bond and oil markets,” Citi wrote in a report published Wednesday.

“This suggests that credit is the single-most underpriced macro risk for the U.S. equity market,” the report said.

Citi analysts argue that price momentum in the stock market—investors expect that equities will power ahead over the near term even if the underlying fundamentals remain the same—now depends on an assumption that risks will remain benign in the credit market.

That could leave stock investors more exposed to a big event in the credit world than, say, a sharp move higher in Treasury-bond yields.

The extra yield, or spread, that investors demand to hold lower-rated corporate bonds instead of safer government debt is starting to edge higher. Bloomberg data pegs the gap at around 2.96 percentage point, 15 basis points, or hundredths of a percent, wider than in late October.

But that only pegs the so-called high-yield spread only 43 basis points higher than the lowest levels of the past year. It isn’t a huge increase, considering the series of defaults in the loan market that JPMorgan Chase CEO Jamie Dimon referred to as “cockroaches” late last month.

A surge in borrowing from Big Tech companies such as Oracle and Meta Platforms , and concerns tied to the huge amounts of debt needed to fund artificial-intelligence data centers has failed to widen spreads in the investment-grade corporate bond market as well.

Bank borrowing from the Federal Reserve’s repo facility, designed to keep the financial system liquid, is on the rise, suggesting the potential for funding concerns.

“Credit spreads are the market’s real-time read on default risk and fear, the quickest check on whether a funding hiccup is bleeding into fundamentals,” said Brian Weisenberger, chief market strategist at Xtollo Investment Partners. “By that yardstick, the signals remain calm.”

Bloomberg’s U.S. Corporate Index of investment-grade bond spreads hit a 27-year low of 72 basis points in September. It has risen only around 10 basis points since.

A sudden change in those premiums, however, could have big implications for stocks. Big tech companies facing higher borrowing costs could elect to use a larger portion of their operating cash flows to fund their AI ambitions. That could reduce the amount they dedicate to share buybacks and dividends.

Banks also tend to retreat from risker lending markets as credit spreads widen. Capital could become less plentiful in other segments of the economy, affecting growth in gross domestic product.

And a collective repricing of equity valuations, based on earnings potential, buyback levels and the broader economic outlook can weigh on stock indexes.

Weisenberger at Xtollo says investors should keep an eye on repo market developments, high-yield bond spreads and the broader outlook for corporate earnings in order to gauge the level of credit market risk.

“If those hold, the path of least resistance [for stock markets] into year-end could stay open, but the mix can change quickly as policy, funding conditions, and guidance evolve,” he said.

Write to Martin Baccardax at martin.baccardax@barrons.com