Markets have had a rough start to 2016.  Global recession fears have risen, and U.S. economic data have disappointed lately.  Lately, markets have increasingly obsessed about the price of oil.  (Today, oil is under $30 a barrel.) An increasing consensus holds that stocks can’t rise unless oil prices go higher.

It wasn’t that long ago the same media worried about ever-increasing oil prices; oil was supposed to have a permanent hundred-dollar floor, the only debate seemed to be exactly how much of a drag the oil “tax” would have on the economy and stock market.  Today, cheap oil is cause for panic.

The thing is, low oil prices by themselves are not a bad thing.  It’s a great thing.  After all, low oil prices is a boon to an economy that imports oil and is 70% consumer-based.  There’s one caveat, though: credit.  And credit is something to worry a lot about.  Oil and credit are connected: much of the growth in junk bond issuance (now called “high-yield” on Wall Street) since the financial crisis came from the energy sector.  Oil at these prices spell trouble for a lot of unprofitable and levered oil companies.  There has been a similar fate in other commodities.

We’re watching the high-yield market, perhaps one of the most important indicators today.  Credit spreads have risen to multi-year highs.  Higher yields portend defaults, and that isn’t good for the bond market or the stock market.

The chart below is the standard high-yield (junk) index, representing speculative-grade bonds’ spread to Treasurys.  Today, junk bonds yield some 9.4% above Treasurys.  The higher the index goes, the less confident the market is about weaker companies’ ability to make good on its debts.

fredgraph

https://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2EY

We’re even more concerned about credit outside the U.S.   The last several years have been a debt binge in almost all corners of the globe, much of it taken out in dollars.  A rising dollar has only made those debts harder to service, and debts have reached crushing levels in many parts.   Foreign markets have fared poorly over the past five years, especially “Emerging Markets.” (Still seems too early to start looking for opportunities there.)

De-leveraging will work itself through overseas, just as U.S. banks and U.S. consumers had to after the financial crisis.   For now, a huge part of the puzzle seems to be the question of contagion:  Fear (and credit) is contagious, and while the U.S. has diverged nicely from the rest of the world, it’s probably not immune.

This is largely why we are positioned defensively today.   Higher amounts of cash provide defense—and the ability to take advantage of better buying opportunities, not just in stocks but in bonds, too, as perhaps yields increase for investment-grade credit.  The way markets have moved, those opportunities may come soon.