2014-02-20

Watching one tea leaf: The relative price of credit


The price of riskier corporate bonds such as high-yield and emerging market debt is measured in terms of extra yield. This is the price of credit, which is measured relative to the highest-quality bond issuers, like the US government. Credit-sensitive bonds are backed by companies with uncertain financial strength, and accordingly have lower credit ratings. Because these bonds represent a category of risk higher than other markets, they often signal distress or economic deterioration before other markets decline. These markets can be good "tea leaf" indicators about the path ahead. Also, when these markets show strength (less excess yield), they often signal better times for stocks and other assets.

But right now the biggest economy in the world is showing signs of stress. The economic numbers from the United States have noticeably weakened. This is a bit surprising because in late 2013, in November and December to be exact, US economic data were showing increasing speed and strength. Factories were humming, exports were rising and housing starts were improving. Now, two months into 2014, it almost seems as though the US economy has hit the brakes.

The reasons for this slowdown are hard to pinpoint. An easy explanation is weather. US weather patterns have been disruptive, marked by storms and way-below-average temperatures. This could explain fewer trips to the mall by consumers and fewer homes being started on frozen home sites. But the data are also slow in California, not just Wisconsin, and the weather in California has been fine. Further, factory orders and exports —factors of production not usually associated with weather fluctuations — have fallen.

So something else must be going on. My explanation is that in this, and in other cycles we have seen, there exist "cycles within cycles," patterns of spending and growth that ebb and flow within the broader economic cycle. We saw this in a pronounced way in 2012 and again, on a smaller scale, in 2013. These cycles seem to occur naturally and are driven by consumer trends, news worries, inventory "overhangs" and other reasons, including weather.

What the investor needs to assess is the risk of recession. Recessions bring the biggest avalanches in stock prices, create government bond spikes, disrupt government spending and also trigger huge increases in company defaults. Recessions are not connected to weather or mini-cycles. Recessions have distinct causes. We know that they don’t occur because people feel like staying home or companies just feel like pulling back; they happen because of the appearance of real constraints on spending. The main culprits in recessions are interest rate increases on a scale that chokes off spending. The second cause of recessions is a notable deterioration in profits, companies making less and less money on sales. Profit erosion means less money to spend and sparks a loss of confidence. Usually these two causes are conflated: Higher interest rates often hurt spending but also cut into corporate profit statements by raising financing costs. Both usually occur simultaneously.

Neither of these two negative conditions is happening now. Profits in privately held and publicly held companies are rising. Also, the Fed keeps telling everyone who will listen that short-term rates won't rise for at least a year. In addition, consumers and most corporations have not taken on a lot of debt in this cycle, and both camps have better cash flow to pay principal and interest than they did in the last two business cycles. There is no credit cycle underscoring this business cycle, pushing growth above the speed limit.

My conclusion — no recession in 2014, because the clouds of recession are not present.

Now, back to the credit spreads of riskier company bonds. What is this measure telling us? Interestingly, this indicator of trouble is going in reverse: Spreads above the AAA bond yield are shrinking, not rising. Complacency, even confidence, exists in the hyper-vigilant world of corporate bonds. The stress of recession would show up there first, in the extra yields that companies pay to finance riskier corporate strategies. Instead, the cost of debt for companies now is falling. Further, when credit spreads reduce or tighten, history suggests that the stock market moves up, not down. High-yield bonds have been a rather good indicator of both future weakness and future strength. The economic news is troubling, but the credit markets suggest that investors can relax.



No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

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