As the current economic expansion in the U.S. extends into its tenth year, interest in pinpointing its end date continues to grow. Though the timing of the cycle’s turn is interesting and important, we are more focused on the duration and shape of the coming recession/recovery period—whenever it may come—and its potential impact on fixed income markets. Given that the traditional levers of economic recovery have yet to return to pre-crisis norms, we expect the coming recession and subsequent recovery period will be U-shaped—a slowdown followed by persistently sluggish economic activity that leads to an extended period of downgrades and defaults among highly leveraged corporate issuers.
Trying to predict the timing of a recession can be a fool’s errand; just ask the many prognosticators who have warned repeatedly of the waning momentum of the current expansion cycle, now at 110 months and counting. Cycles don’t die merely of old age, however, and the probability of recession within the next 12 months remains low; a model from the Federal Reserve Bank of New York based on the spread between 10-year and three-month Treasuries, for example, places it at
That said, the growing sense of anxiety among investors as time goes on is understandable. Though the fiscal stimulus enacted earlier this year has increased the probability that the U.S. cycle will soldier on for at least a few more quarters, a variety of indicators suggest the end likely is not too far beyond that. The unemployment rate has fallen to a cyclical low below 4%, and it's uncertain that enough slack remains in the labor force to support continued monthly job creation in the 175,000 – 200,000 range without causing wage and inflationary pressures. A variety of market indicators—such as the strength of the dollar, increased short-term dollar funding costs of credit spreads and the shape of the yield curve—also are suggestive of late-cycle dynamics.
While the timing of the next recession is an important consideration, perhaps more significant to the performance of long-term investors is the duration and the shape of the subsequent economic recovery. The shape an economic recovery takes depends on a number of factors, including the speed and magnitude of the monetary and fiscal policy response and the reaction of interest-rate sensitive segments of the economy to that response. A V-shaped recession is marked by a sharp, relatively brief economic downturn followed by a pronounced rebound in activity. A U-shaped recession, in contrast, tends to be shallower in depth but longer in duration, with the economy falling into a low-growth malaise for an extended period.
Though assigning a recession’s alphabetical resemblance is a somewhat inexact science, V has been the basic shape going back to the early 1990s when the U.S. saw GDP growth go from 4.4% to -3.6% to 3.2% over the course of six quarters. Even the 2007 – 09 recession following the global financial crisis could be considered a modified V despite the sluggish recovery given the depth from which the economy was forced to rebound. These most recent recoveries were driven by some combination of monetary and fiscal policy followed by a resurgence in the housing/mortgage markets. As described below, however, it’s likely that the next recession will begin with all three of these tools having less potential for meaningful impact than they have in the past. We believe the coming recession and subsequent recovery period will likely be U-shaped and that a persistently weak economic recovery will result in an extended period of corporate downgrades and defaults.
Monetary policy. With the Fed’s estimate of its terminal fed funds rate—the rate that it believes supports an economy with full employment, trend growth and stable prices—at around only 3%, the central bank has limited room for rate cuts should economic conditions deteriorate. Compare this with the 5%-plus levels that prevailed at the onset of the three most recent recessions. Similarly, with conventional policy measures failing to alleviate the economic pain of the financial crisis, the Fed was forced to take a variety of extraordinary steps, ranging from zero interest rate policy to “operation twist” to trillions of dollars in asset purchases. Any future efforts on this front—whether a repeat from the financial crisis playbook or a new innovation such as nominal GDP targeting, a time commitment for a low fed funds rate, or an expansion of the type of assets targeted for purchase—is unlikely to generate the elements of surprise and ingenuity that contributed to the success of the previous one, especially given a flat yield curve that offers little in the way of term premia reductions via large-scale asset purchases. The diminishing returns seen by policymakers in Europe and Japan are a good example of what happens when central banks expend all the arrows in their quiver. And with policy rates remaining very low across major economies, as shown in Figure 1, any stab at coordinated global stimulus at this point is bound to have limited impact.
Fiscal policy. In January 2018 U.S. policymakers enacted $1.5 trillion worth of cuts to corporate and personal taxes, and soon after passed $300 billion in federal spending increases. While this has helped push near-term GDP growth expectations higher, it also has exacerbated already-challenging federal budget forecasts. The Congressional Budget Office estimates the federal budget deficit will approach $1 trillion next year—or 4.6% of forecast GDP—and continue heading up after that. After spiking in 2008 as policymakers sought to battle the financial crisis, public debt as a percentage of GDP has continued to drift higher despite ongoing economic growth, standing at more than 100% currently. With the government’s balance sheet already extended, enacting additional fiscal stimulus in the next recession will be more challenging and potentially less effective given the starting level of public sector debt.
Mortgage finance. Monetary policy is transmitted to the real economy via several channels, with the residential housing market being one of the most effective. Looser Fed policy and rate cuts typically result in lower mortgage rates, creating refinancing opportunities for American homeowners. A 1% refi incentive on a $250,000 mortgage, for example, puts an extra $1,800 per year in the pockets of consumers, the equivalent of a 4% increase in average annual wages. A portion of this money is spent, stimulating economic growth. We’ve seen this pattern repeated time and again as mortgage rates continued to move lower; the average rate on a 30-year fixed-rate mortgage has declined from over 10% in the late 1980s to around 4.5% today.
Mortgages are unlikely to provide a powerful tailwind for the next recovery, however, as the vast majority of homeowners able to refinance at the very low mortgage rates of the past 10 years already have done so. Relatively high home prices and affordability challenges also create headwinds for policy impact. While it’s almost certain the Fed and fiscal authorities will attempt to push mortgage rates lower and support housing prices in response to the next recession, the already-low rates (as depicted in Figure 3) carried by homeowners suggest the incentive to refinance will be much lower than it has been in past recoveries.
The Outlook for Credit in a U-Shaped Recession
One of the biggest current concerns among fixed income investors is the growing credit risk in the U.S. corporate market. Two markets in particular should be in focus: BBB rated credit and bank loans.
A decade of rock-bottom interest rates and steady demand from yield-hungry investors inspired companies to increase leverage, sending the aggregate value of corporate debt outstanding to record levels. All this added leverage has been accompanied by a steady deterioration in the overall credit quality of the market; BBB rated debt now accounts for roughly half of the Bloomberg Barclays U.S. Corporate Index, compared to 38% in in 2007. Further, the BBB market is now one-third larger than the Bloomberg Barclays U.S. Corporate High Yield Index, leaving investors worried that the end of the U.S. economic cycle will result in a rash of BBB downgrades and a disruptive flood of “fallen angels” into the non-investment grade space. Fallen angels are often subject to automatic sale by high-grade index funds and institutional investors such as pension funds that are subject to non-investment grade holdings restrictions, a negative technical that could result in credit spreads in both the investment grade and high yield markets widening to levels that may not reflect fundamentals.
While we too are concerned about the impact of potential downgrades during the next economic downturn, the current composition of the BBB market may provide some surprising support. As we highlighted in a recent paper, there are specific vulnerabilities—and opportunities—among BBB rated issuers. The BBB segment of the corporate bond market is composed primarily of industrials (71% of market value), followed by financial institutions (23%) and utilities (6%). We would argue that financial issuers should be excluded from an analysis of BBB credit vulnerabilities, as we do not believe that the growth of these issues represents a particular problem for investors. Despite improving their capital positions markedly in the wake of the financial crisis, financial institutions now are subject to far more stringent credit ratings standards, which has created an unusual situation in which ratings for these issuers declined even as their credit quality improved.
For investors, it’s critical to identify the nature of existing risks and their potential impacts when this economic cycle turns. Even companies in traditionally defensive sectors may be vulnerable to downgrades, with their historically stable late-cycle free cash flow challenged by debt levels more aggressive than was typical in the past and as they are pressured by a drawn out, weak economic recovery.
While we could derive a downgrade forecast based on historical averages, we think a better way to project the fate of the BBB cohort during the next recession is to consider current market conditions and our expectations for the next recession/recovery cycle in the context of a previous downturn with similar characteristics. We choose the 2000 – 02 recession as our bogey; this industrials-led contraction had the highest level of fallen angels on record, as shown in Figure 4, with a three-year downgrade rate just over 25%. (Note that we are looking at downgrades over a three-year period rather than annually to align with our expectations that the next recession will be U-shaped in nature and thus characterized by less intense but longer-lasting pressure on corporate cash flows.)
Comparing the dynamics of the early-2000s recession with the conditions that prevail today we estimate a three-year downgrade rate of 20% for BBB issues, with the ratings actions biased toward the end of the recessionary period. There are two main reasons we expect BBB downgrades will be slightly less pronounced during the next recession. First, 2000 – 02 was characterized by an exceptional level of corporate malfeasance that we do not expect to reoccur; our analysis shows that 6 – 8% of the downgrades during this period were related to the accounting fraud of companies like WorldCom, Tyco and Enron. Second, the sectors that now dominate the BBB portion of the market—health care, pharmaceuticals, pipelines, cable, utilities, food & beverage—generate cash flows that are more defensive to economic downturns than traditional cyclical BBB sectors. Ratings agencies typically are more patient with—and the market less punishing to—defensive companies with high leverage but modest cash flow deterioration, compared to cyclicals issuers with moderate leverage but significant cash flow destruction.
With the aggregate market value of BBB downgrades likely to be higher than we have seen historically, however, the impact on credit markets will be notable. A 20% downgrade rate applied to the $1.8 trillion of BBB rated issues equates to $360 billion in downgrades, which means that the $1.1 trillion high yield market stands to grow about 33% larger. Of course, the cash flows of some companies will prove more resilient to slowing economic activity than others, and security and industry selection will be critical when the cycle turns.
Another credit market that will be impacted by a U-shaped recession will be bank loans. Bank loans have been a magnet for capital for several years, as investors concerned about rising interest rates increasingly recognized the unique combination of relatively high yield potential and low duration offered by these securities. The popularity of loans among investors has reshaped the character of the high yield bond market, as many would-be public debt issuers have instead turned to the loan market for their financing needs. The U.S. senior loan market has doubled since 2010 and now exceeds $1 trillion outstanding as it continues to close the gap with the high yield bond market. With this growth, however, has come a notable deterioration in underwriting standards, and recent loan issuance has been marked by lower credit quality, higher leverage and fewer lender protections by way of loan credit agreements and bond indentures.
Loan defaults should remain low for at least the next 12 months thanks to strong current and anticipated U.S. economic growth as well as the broad availability of capital. As we discuss below, current underwriting behavior suggests that non-investment grade debt in general—both loans and high yield bonds—may experience greater defaults and lower recoveries during the next economic slowdown, especially if our forecast for a U-shaped recession comes to pass. We’d highlight three trends in loan issuance to support this view:
- Increase in lower-rated issuance. Not surprisingly, default rates grow exponentially at progressively lower ratings. Moody’s Investors Service notes that a record 43% of first-time issuers in the first half of 2018 were rated B32, which typically is the lowest rating acceptable to investors. Meanwhile, 64% of the U.S. speculative grade population has a corporate family rating of B2 or lower, up from 47% in 2006, while the percentage of new loans rated B2 or lower reached an all-time high of nearly 70%. See Figure 5.
- Smaller—or nonexistent—debt cushions. The increased emphasis on loans for corporate financing has resulted in more top-heavy capital structures for borrowers, leaving fewer subordinated lenders to absorb losses before they hit senior secured debt holders. Since the financial crisis, the share of debt that is subordinated to first-lien term loans—i.e., the debt cushion—on outstanding covenant-lite senior loans has fallen from 35% to around 22%. Moreover, loans today also are more likely to be structured as first-lien-only transactions, meaning that loans are the only form of debt financing in the issuer’s capital structure; approximately 25% of covenant-lite deals have been first-lien-only this year, versus less than 10% in 2007.
- Weaker loan structures. The typical loan credit agreement has become less restrictive for issuers, thus presenting greater risk to lenders. Influenced by the growth in M&A activity and leveraged buyouts, the definition of EBITDA within many credit agreements—which impacts much of the remaining protections in the agreement—now includes a meaningful amount of adjustments in favor of the issuer, as shown in Figure 6. Credit agreements in general have gotten more aggressive, allowing the issuer such leeway as asset transfers, greater incremental secured-debt incurrence and an increase in the retention of asset-sale proceeds. Such weakening covenant protections have the potential to dilute the position of first-lien loans at the top of the capital structure.
We believe the conditions described above are indicative of late-cycle loan issuance. While there initially may be fewer defaults in the coming moderate economic slowdown than there were before the shock of the financial crisis (when the financial maintenance covenants that protect lenders were common), these underwriting tendencies are creating credit risks that could lead to an extended and meaningful default cycle once the current economic expansion ends while also making borrowers that become distressed more susceptible to equity-friendly actions.
And while the onset of loan default rates may be tempered by the widespread reduction/elimination of protective covenants, recovery rates are likely to suffer. We believe recoveries on this vintage of loans likely will be 5 – 10 points lower than the long-term historical average of 77%, with greater dispersion given the number of aforementioned aggressive characteristics that have crept into the market. Higher levels of secured debt in the capital structure should push unsecured recoveries lower as well; we expect high yield recoveries to be 3 – 5 points lower than the long-term average of 35%.
Though we highlight BBB credit and bank loans in this report, an extended, U-shaped recession would have wide-ranging implications for credit markets—implications that may be difficult to ascertain from recent historical precedents. Persistently low growth may make it more challenging for companies to reduce leverage or even to maintain it at a stable level. Cash flows are likely to be more volatile, and liquidity considerations will become more important for companies seeking to refinance debt in a weak growth environment.
Emerging Markets Bowed but Unbroken
After mounting a sustained recovery in 2016 – 17 on the back of improving fundamentals, emerging bond markets have struggled so far in 2018. Rising U.S. Treasury yields early in the year detracted from the performance of hard-currency issues, while a strengthening U.S. dollar and general tightening of financial conditions hit local-currency bonds as summer began. July offered some respite to battered markets, but this turned out to be the calm before the August storm; hard-currency bonds ended the month down almost 2%, and local-currency bonds shed 6% to bring their decline from the previous peak to 15%. While investment-grade names came out relatively unscathed, troubles in Argentina and Turkey led a general selloff in high-yielding issuers amid tighter financial conditions.
The 15% contraction in local-currency markets—which includes the impacts of foreign exchange and rates—represents a substantial market event. It ranks among the largest selloffs since the inception of the benchmark JPMorgan Government Bond Index-Emerging Markets Indices (GBI-EM) in 2003, trailing only the 2014 – 15 commodity crunch and the 2008 – 09 financial crisis, and neck and neck with the “taper tantrum” correction of 2013. Historically, we often have seen stronger returns following pronounced selloffs in emerging markets, with significant recoveries often occurring over a one- to three-month horizon; in fact, following the eight previous 10%-plus drawdowns in the GBI-EM, the index on average had recovered close to half of its losses within three months.
For investors, a key concern is the extent to which the financial volatility we’ve seen in the emerging debt markets will impact real economies. We believe it will remain limited. While countries like Argentina and Turkey will see significant growth slowdowns, the positive global growth environment, low inflation rates and policy responses from emerging market central banks and fiscal authorities should limit spillovers to real economies. Of course, sources of further volatility are widespread: Russian sanctions, ongoing heated trade rhetoric that threatens emerging Europe and China, Turkey’s seeming unwillingness to tighten monetary policy further in defense of the lira, the potential for continued dollar appreciation as the Fed tightens, and difficult October elections in Brazil are but a few examples. That said, we still believe the overall case for a potentially substantial recovery in emerging markets debt over the next few months appears strong.
Will Italy Make Nice with the EU?
After March elections failed to produce an outright majority in the Italian parliament, the League and Five-Star Movement—two populist, euro-skeptic political parties—began an extended and fractious effort to form a coalition government, ultimately succeeding on May 31 after 88 days of negotiations and some remarkable market moves; the yield on two-year Italian government bonds leapt by more than 180 basis points at one point, a genuine “tail event.” While the systemic spillover from such movements thus far has been modest, Italian government bonds have remained volatile as conflicting rhetoric out of the Italian government—alternately defiant and conciliatory—has rattled markets concerned that the country will not adhere to the European Commission’s fiscal parameters when it submits its 2019 budget in mid-October.
We think Italy ultimately will take a pragmatic approach to its budget, due in no small part to the inexperience of the two parties now running the country and the fragile alliance that binds them. Swept into power by aggressive populist rhetoric, neither the League nor the Five Star Movement appear to have the political skill to convert their expensive campaign promises from words to policy. Though the Five Star Movement took a larger portion of the vote in March, the League has overtaken them in subsequent opinion polls, exacerbating tensions. As the two parties jockey to enact their fiscal priorities—ranging from corporate and income tax cuts to pension reform to universal income for the poor—political paralysis is likely and a new election in the not-too-distant future is a possibility. In the meantime Italy’s Economic Minister Giovanni Tria, affiliated with neither party, is expected to push through a budget plan that is acceptable to Brussels, debt investors and the ratings agencies.
Major structural reforms are needed to get Italy’s public debt under control, and slowing economic growth isn’t helping. The clash between Rome, the EU and the bond market appears to have impacted business confidence, while nonperforming loans in the banking system remain a headwind to corporate lending activity and thus economic growth and job creation. What’s more, Italian banks are major holders of Italian sovereign debt; additional weakness in Italian bonds—quite possible given the recent attention of ratings agencies—would further stretch bank balance sheets.
Italy in many ways represents a test case for the future of the euro zone. How this challenging confluence of slow growth, political division and burdensome debt is resolved may determine the long-term success of the currency bloc. Investors might take a couple of conclusions away from this. The first is that though it may lie dormant for an extended period, the systemic risk inherent in the euro zone’s structural shortcomings cannot be ignored. The second is that the European Central Bank has very strong incentives to err on the side of caution.