The Rearview Mirror – December 2018: Economy more vulnerable to a sharp pullback in credit availability

Blog of markets and finance edited by Christian Zorico

Economy more vulnerable to a sharp pullback in credit availability

In a video published on WSJ, global economics editor Jon Hilsenrath, delve into three reasons why the Federal Reserve is raising interest rates.


However latest Minutes of the Federal Open Market Committee indicated a less predictive plan for next year. Even do, FED officials announced their plan to raise interest rates again in December, yet they still emphasise that next few moves will depend from upcoming data. The normalisation of policy rates could be reached sooner than later.

Of course, this dovish signal coming from the Chairman J.Powell sent a reassuring message to the market. For instance, the 10-year Treasury yield finally came back below the level of 3%. This is after having touched its seven-year high early last month and triggered risk-off market to other risky assets.

Clearly if the FED has vocally expressed its doubts about the risks behind  some asset classes like the credit, investors should take in consideration the genuine goodness of its future guidance.

The next bomb, or to use a more moderate expression, a further serious widening of the spreads offered by investment grade and high yield companies’, could result from the following circumstances:

  • Historical highest level of total outstanding U.S. corporate debt, with an escalation of almost 90% over last decade, according to Securities Industry and Financial Markets Association data. In fact, if in 2007 the latter was 4.9 trillion dollars, we are now facing a scary figure of 9.1 trillion dollars.
  • If the US economy weakens, a combination of deteriorating corporate profit margins and declining cash flows could undermine the capability for U.S. companies to roll-over their pile of debt.
  • The quality of covenants during last years dramatically lowered, leaving the HY and loans markets more vulnerable.
  • The rates environment could be less friendly for US companies because of less stimulative policy (rates can reach their normal level very soon, but at the moment the quantitative tightening plan is on its due course) and because higher credit spreads requested by the market participants.

Of course this is the worst case scenario, that can ultimately spread its negative effect over the equity and other risky assets. But they are not sufficient themselves to let the entire asset class capitulate.

The magnitude of flows will represent the variable to be taken into serious consideration. We already highlighted the outflows that have characterised the movement of the investment grade paper. At the beginning, the behaviour of the high yield sector appeared to be more resilient but a repricing of their credit spreads has been spurred by the concomitance of outflows and specific stories like General Electric and other OIL related names.

According to Lipper data, loan participation funds that buy loans to highly indebted companies, recorded $1.7bn in withdrawals in the week ended Nov 21. This together with US-based high yield or junk bond funds that saw $2.2bn in withdrawals.

Investors should be worried about a systemic risks associated with these loans and the amount of debt issued by HY names.  And FED members are worried about this issue as well. They are playing their role to calm down an excessive enthusiasm about the path of normalisation. The rest is unknown and so investors should adapt their expectation too about the profitability of this incredible asset class that provided positive return with very low volatility during last 10 years, apart from some specific situation related to the OIL price slowdown and credit funds outflows occurred during last 2 years.

Focus on liquidity of this asset class is a good exercise to estimate whether or not our return objectives are in line with the hidden risk to exit without extreme pain from our investments.

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