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Written by: Mark Cole | Advisor Asset Management
It’s been a wild ride in credit over the last several months with a recession likely looming in the near term, in our opinion. The U.S. Treasury yield curve has been inverted for a prolonged period at this point and has served as an indicator of coming recessions in the past. The severity of the inversion (currently the 3-month/10-year spread of -160bps (basis points)) is likely indicating that we have a less healthy economy than data might currently support at best, or at worst a severe recession. We would expect corporate credit spreads to react negatively in such an environment. However, given that the Federal Reserve Open Market Committee (FOMC) has raised short-term rates 500bps since March 2022 to combat inflation, we have seen corporations deal with the change well thus far. Companies have been reporting relatively robust earnings results (versus analyst estimates) despite the deteriorating backdrop as revenues and continued growth start to slow. Balance sheets have also held up relatively well as management navigated increasing costs with the added benefit of very resilient consumers. Although spreads recovered quite dramatically from the fall 2022 wides, the “banking crisis” of March 2023 reversed that only to tighten again shortly thereafter.
Given that volatility, the question remains, “Do current credit spreads accurately reflect the risk of potentially lower future revenue, growth and earnings?”
In our opinion they do not, and there is risk for widening (rising) spreads as we head toward a recession (mild or severe). However, that may be nuanced as it will most likely be more pronounced in some sectors than in others. Sectors more sensitive to a recessionary environment could be various industrials, metals/mining, chemicals, real estate/homebuilders, leisure and retailers. Other sectors may be able to better cope with such an environment and thus will see wider spreads, but not as wide as the aforementioned.
As the recent “crisis” in regional banks has shown though, there are consequences of higher rates and especially a severely inverted yield curve. In that case, there were some specific situations where risk wasn’t managed properly, but the larger takeaway is in that sector profitability from net interest margin (among others) is impacted. Equity short sellers might have been the culprit for pressure on the equities of even the larger “super-regional” banks, but otherwise they are likely fundamentally ok. It is more of a confidence issue in the banks, which will hopefully return soon as the situation calms. However, a recessionary environment wouldn’t provide much help. As we’ve already begun to see, in a slower-growth environment, banks are going to tighten lending standards as credit worthiness of borrowers becomes more strained. Higher lending standards lead to less lending overall which can lead to lower demand and less growth.
Although rolling over, inflation has remained higher than the Federal Reserve’s target as recent Core CPI (Consumer Price Index) showed a rise of 5.5% from a year ago which means we’re likely to experience a “higher for longer” period for short-term rates. Even as inflation measures cool, consumers will have to deal with higher prices than normal. For example, consumer sentiment also dropped from 63.5 in April to 57.7 in May and consumer spending is likely to decrease as cash balances from stimulus savings dwindles and credit balances rise.
With indicators pointing to a slowdown/recession, we remain positive in our hope it will be mild and short lived. That said, we would expect credit spreads to widen from current levels to reflect higher credit risk. Past recessions have been accompanied by wider credit spreads, but the amount of dislocation hasn’t been super consistent. But we still use history as a guide.
While this note may seem a bit negative, it is part of the credit cycle. We don’t consider a widening of credit — even if pronounced in certain sectors — as catastrophic at all, but more as an opportunity to outperform by reviewing portfolios to better manage credit risk and duration risk through credit selection – ideally using individual bonds to customize portfolios. The debt of lower-rated, more highly levered companies should be more severely impacted in any selloff, while fundamentally sound companies’ debt with wider spreads and higher net yields can be seen as opportunity to outperform, in our opinion.
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