Juggling Dynamite

Risk complacency is evident in exuberantly priced assets.

Stocks do not provide contractually prescribed interest payments or a return of principal date. Some pay dividends, but these are always at the discretion of corporate management and can and should be cut when a company’s financial circumstances warrant it. When a company becomes insolvent, creditors and bondholders have first dibs on its assets; stockholders are frequently left out of the money.

Earnings yield reflects how much profit a company generates per dollar of the stock price paid (the inverse of the price/earnings or P/E multiple) and should be compared to historical averages and the yield available on other assets.

At today’s elevated stock prices, the mean earnings yield for S&P 500 companies is about 3.31%, less than half the historical mean of 7.23%. It’s also 219 bps below the 5.5% average yield presently available on BBB corporate bonds (which have contractually prescribed interest payments and return of principal dates). In this comparison, the large-cap U.S. stocks are as overpriced and unattractive today as in late 2007 and the tech bubble of the late 1990s (shown below). So, stocks are unattractive relative to corporate bonds, but despite what the investment sell side wants us to believe, stocks and corporate bonds are not the only places to put capital.

Government bonds are another contender, and today, the relative yield offered by corporate securities over Treasuries is the least attractive in at least 18 years.

High-yield or ‘junk bonds’ (credit ratings under BBB) offer 279 bps over similar-dated U.S. Treasury bonds today (shown below since 1997)—the smallest yield spread since the now infamously complacent summer of 2007.

By November 2008, as stock and corporate debt prices plunged, junk yields ballooned to 1996 bps over Treasuries. More recently, in the COVID-inspired panic of March 2020, high yield spreads blew out to 877 bps, albeit briefly.
Even investment-grade corporate bond spreads (Baa and higher) at 144 bps today are the lowest in 27 years (shown below since 1986), and compare with a 393 bp spread in March 2020 and 610 bps in November 2008.

Companies borrowed record amounts in the past few years (shown below since 1990), and investors are receiving little compensation for elevated capital risk. Lest anyone forget, corporate yield spreads are on top of Treasury yields. So, for example, as the 5-year U.S. Treasury yield moved from 37 bps in April 2020 to 438 bps at the end of 2024, investment-grade borrowing costs moved from less than 3% to over 5%, and high-yield borrowers to nearly 12% (U.S. effective yields shown below as of December 31, 2024). They’ve risen further in the last week.
Most household and commercial loans through the banking system are priced over prime. U.S. prime rates have moved from 3.25% in March 2022 to 7.25% today and, in Canada, from 2.45% to 5.45%.

Despite central bank rate cuts since last summer, higher Treasury yields mean borrowing costs have risen sharply for most borrowers, which is unusual and the opposite of what most have been banking on.

More than 696 US companies filed for bankruptcy in 2024, up 8% over 2023 and higher than any year since 2010 (S&P Global Market data shown below). Restructuring to stave off bankrupty also rose, outnumbering bankruptcies two to one (Fitch). In the process, priority lenders to issuers with at least $100 m in debt have seen the highest capital loss rates since at least 2016. See U.S. Corp. Bankruptcies hit 14-year high as higher rates take a toll.

There are many moving parts in the world today, and many unforeseeable things can happen. However, investment loss cycles are a constant and predictable outcome of not calculating or overestimating future cash flows. Investors can and should resist risk-blind bets. If you want to gamble, buy lottery tickets.

Many moving parts are pulling in opposite directions. This discussion highlights some big ones.

2025 ushers in one of the most dangerous periods in world history — on par with the 1930s and early Cold War, says Ian Bremmer, president and founder of Eurasia Group and GZERO Media. Highlighting the top geopolitical risks for the year ahead, Bremmer explores the impact of Donald Trump’s return to power in the US, the breakdown of the US-China relationship, the consequences of a rogue Russia, the future of unchecked AI development and more, plus some bright spots amid these unprecedented challenges. Here is a direct video link.

Canada’s unemployment rate rose to 6.9% in December, now up 210 basis points (bps) from the 4.8% low in June 2022 (below in blue). The U.S. unemployment rate, at 4.2%, has risen 80 bps since it bottomed in April 2023. There has never been a time when unemployment has increased this much outside of recessions. Moreover, after 27 months of an inverted yield curve, Canada flashed another recession warning in October when the Treasury curve finally turned upward-sloping—longer yields moved higher than short (shown below since 2020, via Y-Charts).

Record fiscal deficits have undoubtedly propped up the U.S. economy more than Canada’s in the past couple of years. Yet, after a record 28 months of inversion, the U.S. yield curve also turned positive-sloping in December (U.S. 10-year minus 2-year yield below in red, since 1975, with the 10-year minus 3-month yield in blue). There has never been a move to positive sloping after a period of inversion that did not signal the onset of recession (grey bars below).

When the yield curve turns positive sloping (see blue line below since 1985), it has always been followed by months of rising unemployment (in red, since 1985, courtesy of Bravos Research) while central banks try to ease credit conditions for the real economy.

Most developed economies have simultaneously reached this point of faltering economic momentum, rising unemployment, record debt, and uneconomic asset prices. The masses have come to expect governments to backstop everything (an impossible mandate). Incumbents are out of favour worldwide, but this will be harder to fix than just changing figureheads and political parties.

Canada’s Prime Minister resigned, as expected, just as Canada announces more troubling economic data. The whole saga of PM Trudeau’s downfall is actually perfectly illustrated by the loonie; and it applies to a lot more than Canada. It’s a warning to both existing governments as well as the successors who take over for them after voters have had enough. Here is a direct video link.