We are more than a decade into an economic expansion that has already surpassed the longest economic expansion ever recorded in the United States. Equities are up 14%, and high-yields increased by 11% since 2009. Interestingly, even though it has been the longest expansion, it has also been quite shallow in terms of its relative GDP growth when compared to previous movements after a recession. This long-lasting economic growth, along with certain indicators, has investors wondering if there is a recession looming.
Based on economists’ responses to an annual survey conducted by Bloomberg, there is a 33% probability of a recession over the next 12 months. This probability shows an increase from around 10-15% observed between 2015 and 2019.
Interest rates are low all across the world, with negative rates in some countries. Negative yielding debt represents about 25% of the global bond market. The U.S. interest rates range from about 2-2.5% for shorter-duration yields to about 3-3.5% for longer-duration yields. In this low-rate environment, the U.S. interest rates are attractive for foreign investors and have been driving demand into U.S. markets. Currently, the U.S. accounts for less than half of the global investment-grade bond market, but it pays more than 98% of total yield globally.
In August we witnessed an inversion of the yield curve between the 3-month Treasury bill and the 10-year Treasury note. An inverted yield curve sends the signal that the economy in the near term is riskier than in the long term. Since 1956, every recession has been preceded by an inverted yield curve. However, not every inversion of the yield curve resulted in a recession.
The U.S. economy is supported by low unemployment and rising wages. Strong consumer spending in Q3 offset a drop in business investment and kept the decade-long economic expansion on track despite the trade tensions and the cooling of the global economy. The U.S. inflation rate was at 1.9% in December 2018 and declined to 1.8% for the twelve months ended in October 2019. This declining inflation rate is a concern for the Fed, as it may lead to a deflationary cycle. The manufacturing sector is showing slower growth. Manufacturing is a small part of the U.S. economy. Still, certain manufacturing indicators (Institute for Supply Management) are highly correlated with GDP, making them a good indicator of movements in the economy.
Through the third quarter of 2019, the best performance came from the riskiest sectors like equities and high-yields, but even investment-grade bonds provided solid returns. Companies are taking advantage of lower interest rates and are refinancing some of their higher-coupon debt. In terms of fundamentals, we see elevated leverage ratios across the corporate sector, with the debt-to-EBITDA ratio for non-financial issuers of 2.7, which is consistent with 2002 and 2008 when earnings were contracting.
Since 2010, the corporate bond market has doubled in size to $5.5 trillion, and the proportion of BBB-rated bonds has increased from 30% to 50%. Essentially, we are facing a riskier corporate debt market accompanied by an increased probability of a recession. But how much of this debt is at risk of being downgraded? Historically, 5% to 10% of investment-grade corporate bonds fall to high-yield in every recession. In a normal recession, an estimated $225 billion bonds would be downgraded, and in a severe recession the amount of downgraded bonds would double that of a normal recession.
Each year, Goldman Sachs surveys 300 insurance companies globally, and the latest survey shows that 85% of respondents believe the credit cycle is in its late-stage. The majority expects wider corporate credit spreads over the next year. Lastly, two-thirds see the recession as a major cause of concern.
AAM shared the following expectations for the upcoming year:
- Slow but positive real growth
- Stubbornly low rates – limited book yield gains
- Growing demand for non-core strategies
- Periodic credit and equity market volatility
- Opportunities due to liquidity disruptions