High Yield Bonds vs. Small Caps: Which One’s More Likely To Break?
It ALL Goes Back To This
If you look back at the financial markets over the long-term, there are some investing principles that are generally accepted to be true. Value outperforms growth. Dividend payers outperform non-dividend payers. Small-caps outperform large-caps.
Over the past decade (and really since we came out of the financial crisis), a lot of those relationships have been flipped upside down. Years of cheap money policy and trillions of dollars of added liquidity have created an historically unusual environment where large-cap growth & tech have almost exclusively been the market’s biggest winners.
The 40-year bond bull market? Finished. Dividend stocks? Who needs 2-3% yields when you can get 20% investing in pure market beta? Value stocks? Cheap is boring.
One relationship that’s gotten really interesting over the past few years has been that of junk bonds and small-caps. One is hugely overvalued. One is hugely undervalued. Are we setting up for a mean reversion that could crown the market’s next leader?
Junk Bonds vs. Small-Caps: Which One Is Ready To Break/Breakout?
Traditionally, junk bonds and small-caps are viewed pretty similarly within their respective asset classes. High yield bonds have lower credit quality ratings and are, therefore, riskier. According to the good old CAPM, that extra risk should be rewarded with extra return over time.
The same thing goes for small-caps. They’re usually developing, more speculative companies, especially relative to large-caps. Again, because they’re considered riskier, they should, in theory, produce better returns over time.
But these two have followed very dissimilar paths.
Looking back historically, small-cap outperformance and high yield bond outperformance have been closely correlated. That changed about a decade ago. Since then, junk bonds have consistently outperformed higher-quality bonds (with exceptions for the 2015 junk bond crisis and the COVID pandemic), while small-caps have consistently lagged their large-cap counterparts.
It’s gotten to the point now that there’s an historic disconnect between the two.
As the heading to the chart says, either junk bonds are really overpriced or small-caps are really underpriced. But which is it?
Is Japan About To Trigger The Reset?
The thing that really spooked the markets over the past week was Japan. Yes, the reverse yen carry trade and the massive deleveraging that resulted from it exacerbated downside risk, but it’s the economic situation that Japan finds itself in that’s at the core.
Japan has for years kept monetary conditions as loose as possible in order to jump start the economy without a great deal of success. But with inflation struggling to sustainably get up to 2%, the Bank of Japan wasn’t in a big hurry to try to normalize conditions. Now, inflation is starting to creep higher and the BoJ may be forced to tighten whether the economy is ready for it or not.
Over the past 40 years, the Japanese economy has only been able to sustain 2% for short periods of time (and has struggled with outright deflation just as frequently). Today, the inflation rate has remained above 2% for two straight years, the longest such stretch since the early 1990s.
The problem now is that the inflation rate is forecasted to go higher from here. The latest BoJ estimates call for a 2.8% rate in 2024 before potentially cooling in 2025. If that’s the case, Japan can no longer sit on the sidelines and hope conditions can be contained. Last week’s 15 basis point rate hike combined with a winding down of bond purchases and indication that more hikes may be needed is the first serious sign that inflation is becoming a problem.
And that brings us to today.
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