Distinguish Signals from Noise
How can investors tell when late-cycle is turning over into end-cycle? There are two places to look: at data coming from the real economy and at indicators from financial markets.
If financial markets are forward-looking discounting mechanisms, they should begin to demand higher risk premia well in advance of a downturn in earnings or GDP growth. Equity market valuations might be expected to retreat from cyclical highs and credit spreads to widen from cyclical tights. The government bond yield curve might be expected to flatten and invert, as central bank policy tightening at the front end meets lower growth and inflation expectations at the long end.
All three of these indicators were flashing red at the end of 2018. But we believe all three are compromised as economic forecasters in the current cycle.
Yield curve flattening is partly a reflection of how low the starting point for long rates was after years of quantitative easing and subdued inflation expectations, and, in the U.S. especially, partly about the way that short rates are determined by domestic policy while long rates are determined by the global inflation environment.
High yield credit spreads blew out almost 100 basis points from their tights in September and global equity price-to-earnings ratios also retreated sharply. Investors who took that as a sign that markets were discounting a severe economic slowdown, however, would have missed one of the strongest New Year rallies in history.
In our view, moves such as these, in both directions, have less to do with underlying fundamentals than with fragmented liquidity in an environment devoid of traditional market makers and increasingly dominated by momentum-biased investment strategies. We have seen this before. The start of 2016 came as general bad news on China and oil prices coincided with perceived warning signals from widening credit spreads and equity market volatility. As financial markets flashed recession signals, more investors tried to sell into illiquid markets, and the signals flashed more urgently. Three years later, it is clear that this was noise.
Back in early 2016, many commentators played down robust-looking U.S. fundamental data such as housing starts or consumer confidence. But that is where they should have been looking to get a real sense of where the economy was going, not at volatile financial markets.
At the moment, these indicators paint a reassuring, or at worst, a mixed picture. Many indicate that the economy is still mid- or in some cases even early-cycle. Look at the picture outside the U.S., and the data trends suggest that the end of the cycle is even further away: recoveries in European employment, wage growth, inflation and industrial activity still lag those in the U.S., for example.
This mixed picture fits our thesis that structural changes to the economy have re-shaped the traditional manufacturing-led boom-and-bust business cycle we became used to between the 1930s and 1980s, leaving us with much noisier rather than signal-rich economic data, and longer but shallower downturns rather than outright recessions—in the absence of financial shocks.
Source: Citi Research, Institute for Supply Management, Conference Board, Federal Reserve Bank of St. Louis. Data as of March 31, 2019.
Corporate debt is 64% higher than it was on the eve of the financial crisis. But that headline number hides a lot of nuance.
A lot of attention is being directed to investment-grade companies. By 2018, gross leverage in this sector is near its long-term peak of 2.3-2.4x EBITDA, and interest coverage at around 10x is near a post-crisis low, according to Morgan Stanley Research. Almost two-thirds of that outstanding debt matures over the coming five years, potentially putting the sector at risk of rising rates or a spike in risk aversion in the primary markets. Much has been made of the rapid growth in outstanding BBB rated issuance as credit quality has deteriorated in the investment grade universe.
However, it is important to note that financials, the most systemically important sector, has seen its credit profile improve since the financial crisis. And while gross leverage at investment grade corporates is at a 30-plus year high, net leverage is lower than it was around the technology crash of the early 2000s. This tells us that a lot of this debt has been taken on by companies in traditionally defensive, non-cyclical sectors to take advantage of the very low, long-dated interest rates that have been available for the most creditworthy borrowers. Moreover, U.S. corporate debt declined in 2018 as tax-reform proceeds were added to balance sheets, and companies have signaled an intention to de-lever further in 2019.
There are few signs of corporate exuberance in either the U.S. or Europe: M&A and IPO activity remains muted relative to the top of previous cycles, and the level of profits remains modest.
In high yield the picture is mixed. Bond market leverage appears already to have plateaued at 4.0-4.5x EBITDA, back in 2016. It is now heading toward 3x, and interest rate coverage is approaching a post-crisis high, according to data from Bank of America Merrill Lynch. In leveraged loans, however, high valuations in the private equity markets, combined with surging demand from investors seeking floating-rate protection as monetary policy tightens, have been pushing leverage up toward a ratio of 5.5-6.0x EBITDA. Moreover, that debt issuance has been getting more aggressive, coming from lower-rated borrowers, with looser covenants and a smaller high-yield bond cushion in capital structures. A rising proportion has gone to finance leveraged buyouts. The first quarter of 2019 has seen a demand for wider spreads and stricter lending standards, which can be interpreted as a welcome dampening of exuberance or a worrisome sign of cyclical fatigue.
How serious is this situation? A longer-but-shallower downturn would imply a higher default rate than in previous cycles, and lower recovery levels from defaulting bank loans, and that makes a strong case for a quality-focused, fundamentals-driven approach to credit. But we believe the work-out of imbalances in the credit markets is likely to be a long, grinding process rather than the sort of sudden shock that could spark a substantial slowdown in the real economy.
This is mainly a reflection of the fact that China is the world’s second-largest economy and the largest contributor to marginal global economic growth. It has been in a clear growth slowdown over recent years, accompanied by rising government and corporate debt levels and aging demographics. These dynamics have been exacerbated recently by its trade dispute with the U.S.
The authorities have responded with stimulus efforts focused on cuts to individual income tax, enterprise income tax and value added tax, and to the required reserve ratio for banks, and these actions have addressed a number of short-term concerns. There are early signs of success in the growth of credit and the velocity of money, and in some other fundamental data.
But where should investors look for consolidating evidence that these measures are gaining traction? Headline GDP data is considered unreliable and many other economic data sets are patchy, but seasoned China watchers are used to monitoring indicators that are one or two steps removed from the official Beijing data bureaucracy: examples include Markit Purchasing Managers’ Indices (PMIs) and data on electricity consumption, vehicle sales, airline passengers, container ship and rail freight, and industrial apparent consumption of basic commodities.
In China (and indeed, for many indicators, in Europe) we are looking for—and at this stage, still anticipating—signs of bottoming-out and recovery. Over the coming months, data releases in the areas we have mentioned will be critical.
Finally, it is worth noting that the risks described here are near-term. Should they fail to materialize as a recession, it is not clear what the catalyst for recession might be in 2020 or even 2021. This recognition informs our expectations for an extended cycle, but also leaves open the potential for a final surge in risk appetite that could fuel high market returns but also the danger of greater asset bubbles or other financial imbalances.