Hedging the recession risk
The gap between corporate bond index yields and overnight interest rates is as narrow as it gets. Rates have gone up, and credit spreads have narrowed in recent months, with the mini-banking crisis in March proving to have been a great buying opportunity. A soft-landing with no major corporate distress with the Federal Reserve (Fed) keeping rates high for a prolonged period could mean the gap remains very narrow. Yet a hard landing is a non-negligible risk. If economic data weakens, and crucially the US labour market softens, then risk premiums are likely to widen and interest rate expectations for 2024 will fall. There are opportunities to construct a hedged position in case the soft-landing we are in now becomes something that makes managing cash-flows and balance sheets more difficult.
“Resilience” has been a well-used word in recent months, especially in respect to the better-than-expected performance of the US economy. Underlying this rather glib notion is the fact that overall households and businesses have been able to avoid dramatic cuts in their consumption and investment spending. There have been significant headwinds – increased energy and food prices, a general increase in the cost of living, and higher interest rates. These have all come in the wake of the COVID-19 pandemic. Household wealth and income has remained sufficiently healthy to allow consumer spending to grow at an annualised average pace of 2.3% over the last four quarters. The most recent quarter was slower but, under the circumstances, this is not a bad outcome – and companies have been able to manage slower growth, higher costs, and increased interest expenses. As I said last week, as things stand, this all adds up to a soft-landing.
Risk comes with reward
Markets have behaved in line with this macroeconomic narrative. Equities have outperformed bonds. Growth (i.e., expensive) equities have outperformed value. The US market has outperformed the rest of the world. Within fixed income, leveraged loans and high yield credit have been the best performing sub-asset classes in the US. High yield has beaten everything in the European bond market. The traded securities of the most levered companies, many paying floating rate interest costs, have generated significant total returns. The Bloomberg US leveraged loan total return index has returned over 8% so far this year, while the CCC-rated part of the high yield market has returned nearly 13%. Companies which have high levels of borrowing, paying high – and in some cases – rising interest costs, appear to be managing the more challenging macro environment and tighter financial conditions without there being many headlines about credit impairments, bond offerings being pulled or defaults. If there is weakness out there in corporate America, it has not yet become debilitating.
Credit valuations need monitoring
Valuations in credit need to be monitored though. Take investment grade credit. It is an asset class I have liked since last year and has performed well. The ICE-Bank of America US corporate bond index has delivered 3.7% total return in 2023, some 2.6% above an equivalent set of US Treasury bonds. At the same time, overnight interest rates have been rising as the Fed has continued its fight against inflation. The gap between the corporate bond yield and the Fed Funds Rate is currently around 15 basis points (bps) and has been below 50bps since February. As rates have gone up, credit spreads have come down. The current spread component of the overall yield of the corporate bond index is around 21%, the lowest since the mid-2000s. A tightening of monetary policy designed to slow the economy to bring inflation down might ordinarily have led to credit risk premiums going higher, not lower.
Long-rates, short-risk hedge?
A hard landing scenario developing from the current soft-growth patch against the backdrop of a still-hawkish Fed, might suggest shifting away from credit towards relatively less risky government bonds. Reducing equity and high yield exposure in favour of duration might also potentially work. As a hedge, trades benefitting from rising risk premiums and rate expectations falling might also work if the probability of a hard-landing increases. Volatility is low. The VIX, or “Fear Index”, has edged up slightly over the summer, but at a price of 15, there have not been many observations of the index being lower historically. Realised credit volatility, based on credit default swap (CDS) indices, is also low. The US CDX index of investment grade credit-default swaps is currently priced at 62bps compared to a pre-COVID-19 low of 44bps and a level of 111bps last September. On the rates side, the June-2024 US three-month interest rate future is priced to indicate rates at 4.9% by next summer. If there is a hard-landing and inflation keeps falling, there is a chance that rates would be lower than that by then.
Higher for longer
A hard landing requires a change in the behaviour of households and businesses. As soon as this becomes obvious, markets will re-price. It is hard to get ahead of it. Instead, we must watch the data and listen to what companies are saying. Even with continued evidence of a soft-landing, it is hard to think that yields on a credit portfolio will go meaningfully below the overnight interest rate. The US market has traded with a floor on credit spreads around 100 bps. If spreads fell to this level with no change in the underlying risk-free yield, this would give a credit yield of 5.48% compared to the current Fed Funds rate of 5.5%. It would make sense if markets collectively took the view that interest rates would be lower, on average, over the maturity of a credit portfolio holding, but that would logically argue for buying the rates futures (or going long duration). More likely is that the higher for longer scenario for interest rates will cumulatively weaken economic growth, dim prospects for jobs and profits, and the ability to refinance without weakening balance sheets. Risk premiums will go wider and rates expectations will fall in a recession.
Credit wider, stocks down - that’s the risk of a hard landing
The valuation concern relative to interest rates in credit can be extended to the equity market. Based on current expectations, the S&P 500 is trading on a price-to-earnings ratio of 19 times 2024 earnings. This equates to an earnings yield of 5.26% which is below the Fed Funds Rate and below corporate bond yields. There is not much in the way of an equity risk premium and any expected total return outperformance from stocks needs to come from earnings growth. That may continue to come in the technology sector, but the broader equity market may struggle to grow earnings in a hard landing scenario. Historically, there is a 0.7 correlation between moves in the S&P 500 and investment grade credit spreads, and a slightly higher correlation with high yield spreads. If risk cracks, it will all crack.
On a different topic, there have been an increased number of references to the developing El Nino weather phenomena in the eastern Pacific Ocean. This involves the warming of sea temperatures, that in turn, leads to changes in atmospheric weather patterns typically inducing drought conditions in western Australia and parts of southeast Asia, wetter conditions in north-western Latin America, and potentially, a colder than normal winter in the northern hemisphere. There are clear economic implications as well, with food crops at risk including wheat production in Australia and coffee and cocoa in Latin America. So far commodity prices have not reflected the risks with spot wheat prices falling in recent weeks. It is something worth watching as a potential disruptive influence on continued declines in headline inflation going into 2024. This year has already seen numerous extreme weather events and an El Nino on top of these climate change events could be very disruptive in some at-risk regions and communities. Apparently, Peruvian fishermen have already reported an absence of anchovy shoals in traditional Pacific fishing waters because of increased surface sea temperatures.
Extreme temperatures and devastating flooding, together with the potential impact from El Nino present the context for the COP28 meeting in Dubai in December. Given the weariness with which many people have come to treat environmental, social and governance - ESG - investing over the last year, this event will hopefully re-ignite the focus on tackling climate change and the role investors can play. There will be a focus on accelerating emissions declines through the energy sector where the UAE and other Gulf States can play an important role. There will also be further discussions on finance and given the windfall revenues that fossil fuel producers have benefitted from since Russia’s invasion of Ukraine. It would be encouraging if there are proposals to use some of that money, much of it in the hands of sovereign entities, to ramp up financing the transition. Renewable energy stocks could also do with some help given they have traded lower over the past couple of years.
(Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.