Head of U.S. Credit Strategy, Adam Richmond, says investors may need to prepare for bigger challenges as tightening liquidity conditions pressure already weak credit fundamentals.
Rising funding stresses, weaker flows, weaker trading liquidity and, finally, higher volatility. These are the telltale signs of quantitative tightening. Yet, investors began the year very complacent around these risks.
Of course sentiment—and credit spreads—can change quickly, as much weaker fund flows this year suggests. With all of the ingredients for a turn in the credit cycle in place, investors will need to prepare for bigger fundamental challenges in credit in the next six to twelve months—not two or three years down the road.
Although the 10-year Treasury recently hit its highest yield in more than four years, several factors indicate the contrary.
Credit cycles tend to come in two phases: In the first phase, confidence builds, and with it leverage rises and credit quality deteriorates; markets rationalize these buildups.
In the second phase, tightening Fed policy, constricted credit conditions and weakening economic growth (in that order) pressure weak fundamentals; defaults and downgrades soon follow, often feeding back into the business cycle.
In the current cycle, investors have developed a false sense of security, arguing that weak growth for many years has prevented excesses from building. This may be the case for the housing and financial sectors which are in much better shape than they were a decade ago, but investors need to remember that each cycle brings its own risks.
Excesses are out there and—as is almost always the case—the signals are hard to see until after the cycle turns. Nevertheless, we think there are enough signs flashing yellow to indicate that this cycle is on its last legs. Here are just a few of the signs that give us pause:
- Credit markets have grown by 118% in this cycle, and leverage is at unprecedented levels for a non-recessionary environment. And if rated based only on leverage, about 28% of the investment grade index would have a high-yield rating.
- Low-quality BBB issuance was 42% of total investment grade supply in 2017, a record for as far back as we have data.
- B-rated or below loan issuance accounts for two-thirds of total loan supply.
Meanwhile, underwriting quality has deteriorated outside of corporate credit in areas such as auto loans, commercial real estate prices are significantly above prior cycle peaks, and non-mortgage consumer debt has never been higher.
Even in the face of quantitative tightening, weak credit fundamentals, and an increasing number of very late-cycle signals, credit spreads are still very rich.
The Move in Investment Grade Spreads from 87bp to 113bp
Still May Not Price In Medium-Term Fundamental Risks
However, credit markets have begun to turn, and we expect that to continue, as spreads still do not come close to pricing in the true credit risk in the asset class. Investment grade excess returns in the first quarter fell a full 75 basis points, the worst showing since the first quarter of 2008. In fact, the last meaningful decline in first quarter excess returns for investment grade credits were in 2000 and 2008, as those cycles were turning.
We think the tights in IG spreads of 87bp, hit in early February of this year are very likely the tights for the cycle.