(from our Tactical report of 1st November 2016)
Equity volatility and credit spreads are almost perfectly correlated. In part this is because equity is a perpetual option on the solvency of a firm. When credit becomes stressed, equity volatility jumps as well. You can see this from the chart below.
We have shown clients in our Leading Indicator Watch that all leading indicators for credit spreads point to wider credit spreads and higher equity volatility.
The rise and falls of corporate cash flows relative to debt does a very good job of leading the ups and downs of credit spreads, but it also does a good job at flagging equity strength and weakness. It isn’t perfect, but when cash flow is falling relative to the rise in debt, it is not a positive backdrop for equities.