It is often said that equities are about emotion, whereas bonds are about reason. Equity investors tend to ask, “How much can I make?” whereas bond investors tend to ask, ”How much can I lose?” Are these types of investors optimists vs. pessimists? No, but bonds tend to have asymmetric return distributions (to the downside), and equities have a much more symmetric return distribution.
Credit markets are far larger than equity markets, and in the case of corporate credit, they also have priority of claim versus equity. If debt is not worth 100% of its parity, then the underlying equity can be worthless. Accordingly, credit markets frequently dictate whether it is safe and/or wise to be investing in equities. When the credit markets sneeze, the equity markets can quickly catch a cold.
Capital markets are built on leverage, and the banking system is reliant on confidence that this leverage is sustainable and that the system is functioning smoothly. When the financial system’s plumbing starts to gurgle, equity markets are frequently unaware of the pending leverage “unwinds” and predictable selling pressures that arise due to these regularly occurring events.
I have traded credit for over 30 years, and I have seen my share of crises in the financial markets. The Lesser Developed Country (LDC) debt crisis in the late 80’s, Long Term Capital Management in 1998, the Great Financial Crisis (GFC) in 2008/09, and the most recent COVID pandemic-related financial crisis in 2020. Each episode shared some very similar traits that have made our financial system increasingly precarious. We have continued to kick the can down the road by shifting the financial system’s risks towards the ultimate backstops, the central banks (CBs). Unsurprisingly, the CBs have responded by using the tools at their disposal, which manipulate open market pricing mechanisms and distort the risk/return characteristics of the capitalist system.
CBs’ ultimate weapon is the ability to…