- Volatility is back in many segments of the bond market, but there’s no reason to think we’re heading toward a recession in the near future.
- The risks to the corporate bond markets are mostly geopolitical in nature, rather than fundamental or macroeconomic.
- Although we believe there’s still time left in the current expansion, we think there are steps investors can take today to adopt a more cautious stance, including being selective about where on the yield curve to invest and derive their interest-rate exposure, diversifying their portfolios internationally, and being mindful of liquidity risks.
Over the past year, fixed-income investors have become increasingly concerned with trying to assess where we are in the credit cycle and exactly how much longer the macroeconomic tailwinds for bonds can last. Investors are right to pose those questions. It’s been a decade since the end of the last recession, the stock market has set multiple all-time highs in recent months, and consumer confidence is back to prerecession highs. Meanwhile, the U.S. Federal Reserve (Fed) has for three years been normalizing monetary policy, and the yield curve today is as flat as it’s been in years. It’s an environment in which investors are becoming more concerned about a less attractive global growth outlook and rising market volatility, but does the data actually suggest there’s trouble on the horizon?
Understanding the anatomy of a typical credit cycle
Before we try to pinpoint where we are in the credit cycle, it’s worth unpacking exactly what that term means. The credit cycle is typically divided into four phases:
1 Expansion—companies are growing and often issuing new debt
2 Downturn—companies experience deteriorating fundamentals and defaults increase
3 Repair—companies begin cutting costs and restructuring debt, if necessary
4 Recovery—companies are benefiting from improving economic conditions, but remain conservative in their use of capital
The length of each part of the cycle varies. For example, the last downturn, during the 2007/2008 global financial crisis, was short, steep, and severe; the recovery, by contrast, was long and gradual. With that in mind, we believe the U.S. corporate debt market is clearly still in the expansion phase. But the bigger and more significant questions are: How late in the expansion are we? And how much longer can it last?
Credit cycles have distinct phases, but rarely adhere to a timetable
Source: Manulife Investment Management, as of May 31, 2019. For illustrative purposes only. M&A refers to merger and acquisition; LBO refers to leveraged buyout.
It’s an old adage that economic expansions don’t die of old age—and we don’t believe the current one is any exception. The unemployment rate in the United States is the lowest it’s been in half a century, top-line economic growth (as measured by GDP) has been solid and relatively steady, and corporate profits are generally quite strong. There are no truly systemic risks that threaten to cause the kind of global contagion we saw in 2007/2008. There are some very specific risks in the fixed-income market—securitized student loan debt, for example, or the ballooning size of the BBB-rated segment—but we don’t see a scenario that, in the short term, would lead to a significant downturn in the credit markets.
The risks to the markets are mostly political
The biggest risks to the current expansion—already among the longest on record—are primarily geopolitical, in our view. While the ongoing trade dispute between the United States and China has captured plenty of headlines, the tariffs themselves may not be the real threat. Estimates suggest the likely damage rising tariffs would inflict on economic activity in either country remains low. For the United States, total exports to China represent less than 1% of GDP; for China, if President Trump introduced tariffs on all U.S.-bound exports, the cost would be a 0.7% hit to its economy.1
That said, the economic saber-rattling has, in our view, limited upside for either party—particularly given that the real risk to the United States is tied up in investors’ perception of the trade situation. The stock market has been whipsawed in recent months as investors have tried to digest the latest stances coming out of Washington and Beijing, and a prolonged risk-off trade in equities could have a material effect on the real economy in the United States; it’s a risk that shouldn’t be discounted.
In Europe, Brexit remains an on-going source of uncertainty and market turmoil. British Prime Minister Theresa May resigned on June 7 after multiple failed attempts to gain backing in Parliament for the Brexit agreement she negotiated with the European Union. The situation is far too fluid to predict how it might ultimately pan out, but it’s safe to say that the uncertainty will likely bring with it patches of volatility as investors digest the latest developments.
Why we believe there’s still runway left for the expansion
Despite the risks, there are a number of compelling reasons to believe we’ve got time left in the expansionary phase of this credit cycle; we think three factors in particular are worth highlighting.
1 Spreads and defaults are relatively low
As a general rule, by the time bond defaults materially increase, economic expansions are already over. The better leading indicator of the health of the corporate debt market is spreads, or the incremental yield investors demand for taking on credit risk. Since the beginning of 2000, the average spread in the high-yield market has been 584 basis points (bps) (100bps equals 1%); today, the spread in that market is just 378bps.2 Defaults, meanwhile, are also running below their long-term average, which is 3.3% over the past 20 years. Last year, just 1.9% of the market defaulted, and this year we’re on pace for an estimated default rate of an even lower 1.5%.3
The takeaway here is that the risks investors perceive in the high-yield market—as reflected by spreads—remain quite low.
High-yield spreads—often a leading indicator—remain tight by historical standards
Source: Federal Reserve Bank of St. Louis, as of May 31, 2019. The Intercontinental Exchange (ICE) Bank of America Merrill Lynch (BofA ML) U.S. High Yield Master II Index tracks the performance of globally issued, U.S. dollar-denominated high-yield bonds. It is not possible to invest directly in an index. Past performance does not guarantee future results.
2 The Fed is done tightening
The Fed has become significantly more dovish in recent months, which has been welcome news to the markets. After three years of rate increases, the Fed seems to have hit the pause button. Its own projections of future rate levels (which are to be taken with a generous dose of salt) have come down materially over the past year; as of June, the consensus market view seemed to suggest two, if not more, rate cuts by the end of 2020. The outlook for short-term rates matters because it affects both companies’ and individuals’ access to capital; when money is cheap and access is relatively easy, firms and households are both more likely to borrow and reinvest. A more conservative trajectory for rates makes this trend more likely to continue. Absent a full-blown trade war that pushes the economy into recession, however, the risk is that the market is currently pricing in too many cuts in the short term.
The Fed has become much more conservative in its outlook for rates
FOMC participants’ assessments of appropriate monetary policy (%)
Source: bloomberg.com, as of May 31,2019. Each dot represents the level of short-term rates anticipated by a member of the Federal Open Market Committee (FOMC). The size of the dot represents the number of members with that view (i.e., larger dots indicate more members).
3 Balance sheets are strong
Stable and relatively low borrowing costs are particularly relevant in the context of today’s strong corporate and consumer balance sheets. Corporations remain less leveraged today than they’ve been for most of the past decade; consumers, meanwhile, aggressively deleveraged in the wake of the Great Recession and have remained cautious about taking on new debt. The point here is twofold. First, there hasn’t been any evidence of excessive risk-taking in the financial system that could become a catalyst for the next recession. Second, mild increases in risk appetites from either corporations or consumers—or both—could actually help extend the current expansion. As so often is the case, moderation is the key.
Both consumers and corporations have strong balance sheets
Source: Federal Reserve Bank of St. Louis, as of May 31, 2019. The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and shadow banking systems; the leverage subindex consists of debt and equity measures. A positive value for an individual subindex indicates that the corresponding aspect of financial conditions is tighter than on average, while negative values indicate the opposite. The household debt service ratio is the ratio of total required household debt payments to total disposable income.
Factors to consider in the second half of 2019
If we’re ultimately in the late innings of the current expansion, but don’t foresee a recession or significant downturn over the next 12 months, the question still remains: How might investors take a more cautious stance in their portfolios without retreating to the sidelines?
Be flexible with duration
While the short end of the yield curve may be fairly stable over the near term, it’s anybody’s guess where yields on longer-dated securities are headed next. Our belief is that there are more forces working to push yields higher in the United States than there are lower, but that trend may take a significant amount of time to fully manifest itself. The point here is that taking big bets on the direction of long-term rates—especially through exposure to the U.S. Treasury market, the prices of which are driven primarily by investors’ views on rates—may not be a prudent strategy in today’s environment. The source of a portfolio’s duration, or interest-rate exposure, matters quite a bit; we believe a more attractive way to attain it is through allocations to investment-grade corporate bonds and foreign government debt, especially in markets with higher yields and fewer forces likely to push rates higher.
Look overseas for opportunities to diversify
While the U.S. bond market may be in the late stages of the expansion, other markets are in much earlier phases. Brazil, Colombia, and Indonesia, for example, are markets that are all showing signs of strengthening fundamentals, stable inflation, and improving political climates. Emerging markets—especially those where governments aren’t reliant on foreign capital to fund domestic operations—generally offer higher yields than U.S. Treasuries and, in the case of debt issued in local currencies, a meaningful potential way to diversify away from U.S. dollar-denominated debt.
Be cognizant of liquidity risks
Liquidity is, too often, a characteristic investors don’t give a lot of thought to; we don’t tend to miss it until it’s gone. But in an environment where many investors are starting to take notice of where the exits are, having a strategy for managing liquidity is vital. Beyond general precautions around issue size and setting a cap on the percentage of assets invested in any one name, we’d suggest investors take a second look at their sector allocations. Frontier emerging markets and lower-quality high-yield corporate credits, for example, are areas of the market that could experience a lack of liquidity and higher price volatility as expectations for global growth and subsequent central bank policies change over time.