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Dislocation and opportunity
admin | December 7, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The markets over the last eight weeks have both reflected change and caused it. Markets have reflected concern about the performance of corporate credit in a decelerating economy, and the resulting wider spreads across corporate and other markets have tightened financial conditions. Fair value has shifted. There’s emerging dislocation and opportunity.
Tactically underweight 10-year duration
With fair value around 3.00% and with a fair range of 2.75% to 3.25%, current 10-year yields of 2.85% look like a good point for starting an underweight. Lower equity values and wider credit spreads since September have tightened financial conditions, but the market arguably has overestimated the impact on growth and inflation. The Goldman Sachs index has tightened 75 bp since September, and the Chicago Fed’s adjusted index 13 bp (Exhibit 1). Both show financial conditions at some of their tighter levels of the last five years. The market has done some of the Fed’s work for it, and the fed fund futures market since September has taken 35 bp of hiking off the table next year. That sounds reasonable, and the Fed may signal as much in its December dots. But with labor force growth and productivity pointing to fair value in real rates of 1.25% or more and with inflation targeted at 2.00%, 10-year yields temporarily look a little low.
Exhibit 1: Financial conditions have done some of the Fed’s work
Source: Chicago Fed, Goldman Sachs, Bloomberg
Allocate out of corporate into household credit
Much of the spread widening in corporate debt arguably reflects the expected impact of decelerating economic growth on the elevated leverage on corporate balance sheets. As the economy slows, corporations have less gross revenue for paying down debt, and that should demand a higher risk premium. The market has clearly demanded one. The economy looks likely to decelerate further in 2019, so pressure on corporate spreads should continue. The household balance sheet, by comparison, is much stronger. Real median household income and household net worth are at record highs, and household debt service as a percent of disposable income is at a record low. Consumer asset- and mortgage-backed securities should outperform corporate debt.
Emphasize security selection
The sizable moves since September and other developments have opened the door across asset classes for adding to potential gains and trimming potential losses. A few of the more notable:
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The view in rates
The Fed’s dots offered a simple guide to the likely path of shorter rates for most of the year, but the tightening of financial conditions since September has started doing some of the Fed’s work. The market has repriced for fewer Fed hikes next year, and the Fed may validate that at the FOMC on December 19. Absent anything else, fair value along the curve should sit somewhere around 3.0%. Potential tariffs, however, have added risk that the economy could decelerate next year more than expected. For now, assume the market has priced in too much tariff risk and that longer rates will bounce higher from 2.85%.
The view in spreads
Credit spreads should continue widening until they have priced fully for decelerating growth next. Slower growth poses risk to the nearly $3 trillion in ‘BBB’ credit, especially the most highly leveraged names. Names that show organic growth or use free cash flow or asset sales to pay down debt should perform the best. Wider spreads in corporate credit should put pressure on other spread assets, although consumer debt should show less volatility. Agency MBS, which also will need to adjust to likely falling bank appetite, should widen, too.
The view in credit
Although corporate balance sheets have to deal with higher leverage, household balance sheets looks strong. The weakest pockets on the household balance sheet look like subprime auto credit and student loan debt.
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