Credit vs. Stocks: Which Better Predicts Recession?

By Boyd Erman

Which is a better predictor of a U.S. recession -- trading activity in stocks or the corporate bond market?

One of the enduring memories of the last recession and market rout is how equities sailed blithely on to new highs for a few months in 2007 while bonds were sending signals that the world was in deep trouble.

Are bonds always leading indicators? Moody's Capital Markets Research Inc. set out to answer that question by looking at the last three recessions, and to try to apply the findings to what's happening now in markets, given that the big question out there is whether the U.S. is headed back into recession.

The answer is what common sense tells you the answer should be: Look to where the recession began for the signals. If it's a credit-driven recession, the best signals lie in the credit markets.

"The market that is the most directly affected by the proximate causes of the downturn sends the best signal," wrote analyst David Munves, divisional managing director for Moody's Capital Markets Research. Mr. Munves looked at the activity in corporate credit spreads and U.S. stock prices leading up to the 1990-1991 U.S. downturn, the recession of 2001 and the deep downturn of 2008-2009. (Corporate credit spread data prior to 1989 wasn't good enough to draw solid conclusions from.)

In 1990-1991, Mr. Munves attributes the recession to a spike in energy prices because of the Gulf War. In that case, neither market had any deep insight (though credit markets did have a "an edge" because they understood the issues with the high yield market, which was collapsing at the same time.)

In the leadup to the 2001 recession, credit again signaled some of the problems ahead long before equities started to sell off. Credit markets were starting to sense the problems with Russian and Asian markets, and with Long Term Capital Markets.

“In 1998, the equities were totally transfixed by the dot-com boom, and the credit markets were very worried about Russia and LTCM,” Mr. Munves said in an interview.

In 2007, it was clearly the credit markets that saw the train coming first.

Mr. Munves' findings led him to state that the best signal comes from the market "that is the most directly affected by the proximate causes of the downturn." So how does that apply to the current markets? Mr. Munves says that he expected to find a stronger signal from credit markets than equities, but that wasn't quite the case.

“I thought the case for the current downturn, which is what we have to worry about the most, would be stronger for the credit markets, but there’s really not much to choose between the two markets,” he said in an interview.

The one exception was “equity markets got a little overexcited following the sovereign support package in June, and the credit markets had a reflexive rally but there was a little bit of been-here done-that,” he said. Still, the signs are troubling, with Mr. Munves saying that Moody's is "fairly negative" on the outlook for corporate bond spreads.

"We believe the credit market signals, at least, are prescient," Mr. Munves said in his report, adding later that "not all market dips lead to recessions, but spreads signal that this one could."

Both markets are signaling trouble. "We believe the credit market signals, at least, are prescient," Mr. Munves said in his report, adding later that "not all market dips lead to recessions, but spreads signal that this one could."