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Risk dances to the Fed’s tune

| January 11, 2019

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 market’s tentative conviction that the Fed might not tip the economy into recession has given corporate credit and equity a reprieve from steadily wider spreads and lower equity values. High yield spreads and equity valuation, at least as an earnings spread to Treasury debt, stand near their averages of the last decade. Investment grade debt stands wider. That sounds about right for now, but investment grade debt could pull other markets wider this year.

It’s always hard to tell if equity drives debt or debt drives equity since they are both part of the same balance sheet. Investment grade debt now stands at a spread of 142 bp to Treasuries for cash securities, wide of its 7-year average of 127 bp (Exhibit 1). High yield debt stands at a spread of 452 bp, just below its 7-year average of 457 bp. The earnings yield of the S&P 500 now stands at a spread of 295 bp to 10-year Treasury notes, slightly below its 10-year average of 325 bp. The S&P also stands at a spread of 478 bp to 10-year TIPS, inside its 10-year average of 524 bp.

Exhibit 1: Investment grade, high yield and equity valuations have widened toward their 7-year averages

Source: Bloomberg, APS

These levels might argue for fair value if the assets today on average look like the assets of the last 7 or 10 years. For investment grade debt, that is undoubtedly not the case. The ‘BBB’ share of investment grade debt has gone from 31% in 2010 to more than 50% today, and the absolute amount of ‘BBB’ now approaches $3 trillion. Rating agencies have also extended the windows for some highly leveraged companies to reduce their debt loads. The risk to the broader economy comes from the ability of these leveraged operators to navigate a likely slowing this year in economic growth. Some companies have started to talk about reigning in equity buybacks and paying down debt to help navigate the risk of slower revenue growth, but mergers and acquisitions that leave balance sheets high leveraged continue, too.

The Fed has wisely started to pay attention to the signals from debt and equity and moderate its march to higher rates. It may decide that equilibrium fed funds is lower than previously expected. The Fed seems to be signaling a pause, or at least the market has taken the signals that way. Still, corporate balance sheets will have some work to do even if the Fed pauses since growth looks likely to pose a challenge of its own. If corporate balance sheets reposition, then current spreads may look like fair value in hindsight. But the incentives to add earnings per share through leverage and drive equity valuation are powerful. It’s too soon to say that all is well.

* * *

The view in financing

Secured funding rates in the last week have fallen below the upper bound of the fed funds target range.  Each successive day’s trading range came in lower than the previous day’s.  However, in the weeks to come the secured funding markets should see increased issuance in commercial paper and increased issuance in 1- and 2-month Treasury bills, which creates competition for cash that might invest in repo. The trading range of repo looks likely to be 2.55% to 2.45% for Treasury collateral with slightly higher rates for MBS.

Despite softening funding rates, the term premium and turn premiums continue to look outsized.  On average, despite no hikes in fed funds price in the futures market for 2019, each month is worth more than a basis point on average with large jumps for funding over quarter end.

The view in rates

Fair value on 10-year notes stands above 2.75% and ultimately closer to 3.00%. That should mean rates rise from current levels around 2.70%. The slope of the curve will depend heavily on signals from the Fed. If the Fed signals more hikes in 2019, the curve should flatten with shorter yields rising while longer yields fall as investors worry that the Fed could tip the economy into recession. If the Fed signals no more hikes, that could steepen the curve as concerns about recession ease. For now, the delicate balance between Fed policy and potential growth dominates all other rates concerns—tariffs, government shutdowns and others included.

The view in spreads

Spreads in investment grade, high yield credit and leveraged loans all tightened over the last five sessions after widening almost throughout the last quarter of 2018. Spreads in agency MBS, which widened to mid-November and then tightened afterwards, continued to tighten. The reprieve in credit may not last.

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 should perform the best as concern about recession increases the chances the Fed might start reinvesting portfolio principal.

The view in credit fundamentals

The upcoming corporate earnings season should provide the first look at results in the last quarter of 2018 and the outlook for 2019. Consensus forecasts for real GDP suggest real growth slows through 2019 toward a 2.0% pace in 2020. ‘BBB’ corporate balance sheets may have trouble managing debt service if slowing growth puts pressure on revenues. Management may need to trim equity buybacks and reduce debt. Households, however, look strong. Unemployment should fall through 2019 even as growth slows. Strong net worth and manageable debt service should help households, too.

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jkillian@apsec.com
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