The purported ancient Chinese curse, “May you live in interesting times” is an appropriate starting point for a conversation about the current state of credit markets.
Just a spoiler before going further: the saying is neither Chinese nor ancient. Its origins are recent and western deriving from Frederic R. Coudert’s opening remarks at the Proceedings of the Academy of Political Science, 1939.
While this may seem worlds away from the vagaries of modern day fixed interest, the words still have a resonance.
In the yin and yang between fixed income investors and equity investors, the fixed income crowd can lay claim to a decent record in foretelling recessions. In particular, widening credit spreads have historically been harbingers of recessions (Figure 1).
So the recent credit spread widening trend, and sharp sell-off in September, caused some observers to opine that the global economy was heading towards trouble. Spreads have risen to levels normally only seen during recessions or major geo-political crises.
The current state of this previously reliable signal is proving to be quite intriguing.
While major economies including those of China, Japan and the EU are at various stages of dissatisfaction from a growth perspective; the US economy continues to move forward and is nearing full employment.
The answer to this riddle is nuanced, a simplistic binary forecast of whether or not a recession is coming won’t do.
Our view is that a posse of macro dynamics have helped to push credit spreads wider, rather than any blunt recession threat.
US rate cycle finally turning
It’s been seven-years on from zero-bound interest rates plus a period of quantitative easing, and now US monetary policy is taking another step towards normalcy.
In turn, investors are demanding a larger premium for the uncertainty that accompanies potential higher cash rate cycles. Said differently, investors are requiring recompense for the removal of unconventional monetary policies that have whittled away the term premium – the compensation required by investors for holding long-term debt as opposed to continually rolling over short-term debt securities.
We delved deeply into this issue in our July Red Paper The term premium is down but not out: prepare for its return.
Typically, economic growth drives a reserve bank’s hiking cycle, which in turn causes spreads to narrow. But this time around the economic recovery has been unusually weak and protracted so monetary policy has stayed looser – actually ultra-looser – for longer.
With ultra-looser for longer nearing its end, many corporate treasurers have rushed to lock-in cheap long-term funding as the Fed’s hiking cycle gets underway. In doing so, they have on occasion displayed a willingness to give up a few basis points to get the deal done. That may be pragmatic and understandable, but also contributes to spread widening.
Oil price rout
The slump in oil and other commodity prices has been a powerful economic force for the past 18 months. In June 2014 the oil price stood at, what from today’s vantage point seems a lofty, US$100 per barrel (Nymex). Recent lows have dipped below US$US40 per barrel.
That’s been positive for consumers and consumer-related industries, but a headwind for oil producers and revealed itself in credit markets where oil-exposed sectors’ spreads have ballooned to reflect their added risk (Figure 2).
Energy issuers account for about 13 per cent of the US investment grade index while mining companies account for a further three per cent; the out-sized move in their spreads has pulled index averages higher.
An outburst of credit issuance has also contributed to spread widening with May standing out as the month of saturation. By August, the total amount of investment grade bond issues was nearly 50 per cent higher than the long-term average (Figure 3).
But it wasn’t just the volume of debt that hit the market – it was the nature of the deals which had the biggest impact.
M&A activity has been booming, particularly in the US (Figure 4) where a slew of mega-deals with very large debt-funded components have been chipping away at corporate America’s financial metrics.
The nature and volume of these deals has seen many issuers becoming price takers. Once regulatory approvals are obtained the acquirers are naturally eager to close the deal so debt funding becomes more time sensitive than price sensitive. With a focus on getting the deal over the line, some have been willing to offer increasingly attractive discounts.
With large concessions being given to entice investors to participate, there have also been instances of current holdings being sold to make way for the attractive new deals, which in-turn can place pressure on secondary market prices.
The current enthusiasm for M&A reflects a general loosening of the ultra-caution that was commonplace across the US corporate landscape on the heels of the wrenching events of 2008/09. Fast forward to today and debt is cheap and many corporate treasurers are prioritising returning cash to shareholders over protecting debt metrics. Share buy-backs and dividend payouts are at record levels.
As a result aggregate net leverage has risen steadily and the average rating of the investment grade index drifted lower from 2008 to 2014 although it has been more stable over the past year (Figure 5).
However, low interest rates mean that interest cover is steady, or in many cases a little higher despite the higher leverage.
Higher rated companies have become more willing to see their ratings downgraded, as long as they stay within the investment grade range (Figure 6).
Despite the relative loosening of metrics, some perspective is required.
American companies have not morphed from being paragons of financial virtue to spendthrifts. Change has been moderate in a historic context. It’s estimated that the moves only explain about 5-10 basis points of the index widening over the past year.
The combination of macro factors do not, from our vantage point, explain the magnitude of credit spread widening evident over the past year.
Predicting recessions is a paradox. If a truly reliable indicator existed, downturns could be avoided and the indicator would make itself redundant.
As the Nobel Prize winning economist Paul Samuelson quipped, “Commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions!”1
The market lacks perfect information and with so many variables at work, it is important for investment professionals to employ a comprehensive process rather than over-read individual signals or rely on whimsical intuition.
We have our own set of signals that we see as being potential precursors to an economic downturn. We posit that the more of these indicators that are in the red zone the higher the risk of imminent recession.
We group the turning point indicators into three categories (Figure 7):
1) Corporate behaviour – signs that companies have become over-enthusiastic about chasing growth and are taking greater risks.
2) Economic fundamentals – signs that the underlying economy is nearing a cyclical peak.
3) Market Indicators – signs that financial market valuations are rich and investor conviction is wavering.
US firms have clearly become less risk averse evidenced by higher leverage, greater M&A activity and most worryingly debt issuance currently weighted to the benefit of shareholders.
By contrast, pure economic terms are more comforting: monetary policy is still highly accommodative, inflationary impulses are contained and it’s only lending standards which seem to be tightening up. Moreover, a clutch of market indicators ranging from the VIX “fear index” to Treasury yields are looking steady.
So, in summary, we view the US credit cycle as mature, rather than stressed. As the cycle extends the probability of a recession must eventually rise, but there are not yet enough red flags to warrant serious concern. Instead, with credit spreads priced as if a recession is looming we see opportunity.
However, with numerous companies still seeking to satisfy activist shareholders and some industries under genuine stress credit investors need to discriminate between sectors, industries and individual securities to win.
More than a US-only story
The US invariably dominates conversations about business and economic issues. Nevertheless, it would be a mistake to have a US-only view.
Europe’s cycle however, is not as advanced as the US’ (Figure 8), so we see more upside potential there. The fragility of Europe’s recovery has led to more cautious corporations and weaker (but improving) economic measures.
The European Central Bank’s (ECB) quantitative easing program is pushing forward with its attempt at stimulus even if December saw only a moderate extension to the bank’s bond buying program. Markets are awash with funds as with the benefit of the Fed’s example the ECB is working to lift economic growth.
Domestically, we see the progress of the Australian credit market lying somewhere between these two economies. The mining boom helped insulate Australia from the great recession and now, as the boom fades, most companies remain cautious with management maintaining conservative balance sheets.
But the economy is fragile as it transitions from mining-based growth to other engines. Amid plenty of scaremongering about impending recession, the RBA remains accommodative and the lower dollar is stimulating activity.
There is no fool-proof method of divining an impending recession but a good funds manager will be able to gauge when danger signs are growing.
The thing about credit cycles, like people, is that you never really know how long they’ll last. While we may be at a mature phase, we could be here for a long time.
By offering a summary of the framework we use for assessing the credit cycle, we’ve tried to paint a picture of where we think the US market is currently sitting. While some indicators point to a “mature cycle” position, we don’t think we’re late cycle yet.
In fact, we think there’s a little bit too much fear priced into credit spreads, and we think it offers an opportunity. But of course bottom-up homework is critical.
We want to avoid holding those companies that might still launch a re-leveraging program or an aggressive acquisition and instead seek out those that can retain their credit ratings or perhaps even improve them.
Is the credit cycle over? We don’t think so, but it’s certainly mature. Auto-pilot credit investing won’t suffice anymore. The age of intensive research based credit investing is back.
1Samuelson, Paul (September 19, 1966), "Science and Stocks", Newsweek: 92
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