I have been pretty sanguine about the markets and the US economy. Yes, the commodities complex is worsening, but that doesn’t mean this feeds through enough into other sectors to force the market down. And the real economy isn’t at stall speed yet either.We just aren’t there yet. Nevertheless, I have a general read on how this ends regarding credit cycle weakness, increased defaults, asset class contagion, falling markets, economic weakness, and recession. So let me sketch out for you the framework I’m using as a lot of the telltale signs of credit cycle weakness are already happening.
Now, to be clear, I am not calling a recession yet – far from it. After all, the Federal Reserve is raising interest rates, something that it does when the economy is doing relatively well. And while I don’t think the Fed necessarily gets it right, I don’t think they are that far off the mark. Yet, at the same time, the evidence is mounting that the credit cycle is pretty far along and that means asset class contagion and real economy weakness is not far behind.
First, as a former junk bond guy, I tend to think junk is a canary in the coalmine – and for two reasons. First, lower quality credits are more vulnerable to swings in the economy. And second, bond investors are more attuned to downside risk than equity investors simply because bond guys get a fixed income with little or no upside. Right now, junk is signalling problems. Overall, what we’re seeing is lower credit quality that is leading to a wave of bankruptcies. Through the end of November, S&P lowered the ratings for bonds with a face value of $1 trillion, an increase of 72 percent over the entire last year. Conversely, S&P has upgraded far fewer bonds, the face value declining year on year by over a third to less than $500 billion.
In market terms, here’s how the Telegraph puts it:
The first red light on the dashboard appeared in July, when analysts at Bank of America Merrill Lynch pointed out the huge gap between high-yield spreads and equity volatility – a good proxy for the level of complacency among equity investors. On August 14 the gap reached its widest level since March 6, 2008 – less than a fortnight before the financial crisis kicked off in earnest. The equity market sell-off over the summer closed the chasm a bit but not completely. The question now: was this the quake or just a pre-tremor?
The signs are not good. Yields on debt issued by US companies with a credit rating of BB or lower (and therefore not classed as investment grade) have continued to rise. Prices (which move in the opposite direction to yields) are down 2pc for the year (even when you factor in interest payments) and are on course for their first yearly loss since the financial crisis.
Here are some charts from Deutsche Bank via FT Alphaville:
And, of course, defaults in this market are now rising instead of falling – in large part because of the energy sector. The Telegraph reports that we have seen over 100 defaults this year worldwide versus 62 in all of 2014. They also report Moody’s having 37% more companies on their distressed credit list than a year ago. All three major ratings agencies expect defaults to continue rising in 2016 as well. These are potential signs of the credit cycle turning down.
With natural gas and oil prices persistently low, there is no reprieve for high yield energy companies. Eventually we will see a sudden stop of credit to Ponzi companies who cannot remain afloat without having loans rolled over. And by Ponzi I mean it in the Hyman Minsky way ,where he talks about the last phase of a credit cycle, the Ponzi credit phase, as being sustainable only through higher prices. With commodity and energy prices lower for longer, this is not going to be a sector mid-cycle pause without significant pain. We are clearly headed into a major shakeout period.
So how does this infect other markets? Whenever there is a system-wide panic, a large part of this is driven by people selling what they can, not what they must. So, what we need to – and eventually will see – is redemptions – mutual fund and hedge fund redemptions. And when people start to pull their money out of funds, that’s when previously uncorrelated assets become highly correlated. Say, you’re a fund manager in a bull market like the we’ve had. What that means is you have little cash on hand for fear of under-performance. And so when a sector like energy high-yield starts to crater, and people pull their money out, enough redemptions come in, such that you are forced to sell. But what do you sell? You might sell some of the energy bonds you have that caused the redemptions in the first place. But inevitably you and some of your competitors will be forced to sell good assets too, not because you necessarily want to but because you must. And that’s where the contagion begins.
Moreover, when a credit cycle turns down, banks with significant exposure to poor credits will start to husband cash and scrutinize not just deals in hard hit sectors like energy but all credit decisions generally. That means higher rates on loans and less credit available. And this is going to have a knock-on effect of making lower quality credits outside of the energy also less attractive from a balance sheet perspective. To a large degree, this has already begun. Here’s the Telegraph again:
Some analysts note that a lot of the pain is being felt by companies in the energy and mining sectors as the low price of oil and China slowdown begin to bite. But, equally, borrowing costs for the lowest rated non-energy companies are also rising and non-commodity companies are carrying record levels of debt. Bankers report that investors, who until recently were gobbling up any new bonds that came their way, are now turning their noses up at those securities issued by the very riskiest triple-C-rated companies – another cause for concern.
Deutsche Bank puts it more bluntly:
From its starting point in energy a year ago, it has now reached other commodity-sensitive areas such as transportation, materials, capital goods, and commercial services. But it did not stop here and is also visible in places like retail, gaming, media, consumer staples, and technology – all areas that were widely expected to be insulated from low oil prices, if not even benefitting form them.
Deutsche is talking about default rates ex-energy at 3.5%. That is significant.
So, this is the contagion we are seeing. And we should expect to see it increase. This doesn’t mean panic or meltdown or recession, by the way. But it will mean losses for many investors. Having said that, I do believe the credit cycle more generally is turning down and this is an event associated with lower market returns or losses, perhaps large losses, as well as with recession. For the US, the capex environment in oil and gas will be a big part of whether we see recession in 2016.
Just today we saw there significant announcements of capital expenditure cuts in the oil and gas sector: ConocoPhillips, Chevron and Murphy. And these were deep, deep cuts. Chevron is cutting 2016 capex by 24%, ConocoPhillips by 25%, and Murphy by a massive 60%. The differential in cuts is a testament to how size allows the majors to ride out this storm. But it also highlights why high yield credits are going to be in trouble.
My read is that we have now reached a point where the sudden stop of credit to energy high yield is coming. When this occurs, there will be a wave of bankruptcies. Likely, however, the carnage will cause high yield to under-perform and for investors to shift portfolio preferences. When they do shift, fund managers will sell good assets with bad – and that’s when we will see significant contagion. How significant the contagion is depends entirely on how much the real economy is affected by the energy downturn because even a panic can be overcome if the real economy is not in distress. So far, the effect of lower energy capex has not put the US economy at stall speed. However, the contagion to other credits has already begun – at least in high yield. And that certainly means there has been some real economy contagion as well. With the Fed raising rates in 2016, the risks are that much greater, both for investors and for the real economy.