AAM Viewpoints: The Concern in the Credit Markets
While the equity markets hover at – or are making new – all-time highs, the other three stool legs of investments get only marginal attention. However, the size is much greater than the size of the stock market capitalization of the world. Credit markets globally total over $250 trillion, currency markets total just over $95 trillion, commodity markets are estimated to be over a couple hundred trillion, while global equity market capitalization is $89.6 trillion. Since each topic should be given more attention, we will look at credit markets today and save the currency and commodity for another time.
The proliferation of debt started its ascent when we hit a peak in interest rates in 1982. Since then the amount of total debt has risen by nearly 1,100%. This by itself should be crippling; however, we must also then compare the cost of basic interest to support the debt. Based on the Bloomberg Barclays U.S. Aggregate interest rate coupon, the total cost of the interest – based on simple math for comparison purposes only – rose 350% during that same time frame. Still, a massive increase in the cost, but not near enough the impact as one who measures the total size increase of the market would think.
The amount of refinancing higher coupon debt has been a consistent pattern for corporations, governments and municipalities…not to mention households’ ability to afford higher-priced homes or increase marginal take-home income monthly to fund increased consumption. However, there comes a point where the levels of refinancing and replacing higher cost debt hits the top of the S curve and only marginal gains are made. What happens when only marginal gains are made to the true weight of the increased debt load? We believe that we will then begin to see a complex chess match where pawns are no longer sacrificed, but rooks and knights are shifted in desperate measure to meet urgent cash needs when recessions occur. This is not a current situation as the Federal Reserve has supplied enough credit support for the corporate credit markets, but the same cannot be said for municipal markets yet. We believe there is value in certain strained credits in the corporate arena, but you must do quite a bit of credit work and properly evaluate short-term cash strains over the short run to ride out a potential prolonged recovery. Corporations are on pace for over $2 trillion in issuance this year, which should be a glass half full for analysts. It is half full in that the markets are functioning for companies to access credit, but it’s half empty in that the sheer magnitude of the increase in size begins to put the longer-term supply demand strain in focus. Municipal credits and the lag impact of financial reporting warrant portfolio reviews and higher potential shift to states that are less impacted by the pandemic recession and slower recovery projected, in our view.
The Treasury market and addiction of sub-1%, 10-year yields for instructional buyers explains the sheer lunacy of the situation we currently find ourselves. As the recent Federal Reserve meeting appeared to be an Alcoholics Anonymous meeting where they offer an open bar, rates are not projected to rise for several years. Considering their track record for accuracy on projecting forward rates, we would not pay much attention to that statement. Consider what has occurred after economic recoveries when breakeven inflation rates dropped to levels we hit recently and what that spurred the Federal Open Market Committee (FOMC) to do. When breakeven inflation rates declined 1 standard deviation of the long-term trend, we saw a near 3.0% annualized consumer-based inclination rate around 15-18 months later. This is well beyond the comfort target of the Fed and would also correspond to growing economy, lower unemployment rate and would give the FOMC the all clear to increase rates.
As everyone monitors the volatility index for equities, very little concern is paid to the Treasury volatility index. Over the years we have made note of the MOVE index from Bank of America Merrill Lynch which measures the volatility in the Treasury market, however, it is now sitting at all-time lows since it began being measured in 1987. This points to a historical level of apathy among U.S. Treasury investors that should make one’s hairs on the back of their neck perk up. For the Bloomberg Barclays U.S. Treasury index, we believe one should consider taking special note that the amount outstanding has increased just under 12% annually since the end of the last recession in 2009, the yield to worst is standing at near all-time lows at just 0.50% for the entire curve, and the average coupon is at an all-time low of 1.97% which we believe all point to a massive duration risk for investors.
When considering the vulnerabilities of the markets, it’s important to take special note of the credit markets and what to be prepared for. Moving forward there are certain portfolio components that we believe should be considered:
- Actively managed fixed income management to navigate the land mines of credit risk, interest rate risk and could distinguish between real and imaginary headline risk.
- Tactical shifts should be discussed, at minimum, in the municipal arena where certain vulnerabilities may occur based on the lagging information one receives from state and local governments.
- Consider credit barbells strategies rather than just ladders to tactically optimize risk and reward.
- When implementing portfolios, consider current yield pick-ups and spreads to historical norms to see how vulnerable one is to shifts in the yield curve.
- Should you pick up above-average spreads to Treasuries, consider this a buffer to the FOMC raising rates versus potential total return.
CRN: 2020-0908-8561 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.