Two rosy outlooks and a caveat

21 Jan 2013 by Jim Fickett.

If the Fed succeeds in keeping interest rates (corporate and mortgage rates as well as Treasury rates) low, perhaps those expecting the US recovery to be stable for some time are right. However if defaults or some other trigger cause rates to rise, this could bring on recession.

Today Michael Biggs at Deutsche Bank, the originator of the credit impulse concept, mailed out a summary of his global outlook, which is rather positive for the world, for Europe and for the US:

  • The global credit impulse turned positive in Q2 and remained positive in Q3. We expect the trend to be maintained into early 2013, and for the recent improvement in global GDP growth to be sustained.
  • The most interesting developments from a credit impulse perspective are probably in the euro area. Credit growth has started to stabilize, and, if the current trend continues, the credit impulse will return to neutral and demand growth will surprise positively. We expect the PMI to reach 50 in Q1 2013, and euro area GDP growth to turn positive in Q2. …
  • In the US the credit impulse fell to zero in Q3, and is likely to remain there in Q4. However, we expect the impulse to be back in positive territory in 2013, and for the above-trend demand recovery to be maintained.
  • From a sector perspective, the mortgage impulse was positive, but the business impulse recovered slightly from negative levels. Residential investment should remain strong, and business capex growth could recover in early 2013.

Note that the positive outlook is dependent, in part, on business investment continuing to improve. And this in turn is dependent on the very cheap financing currently available to even very low-rated companies.

Bill McBride at Calculated Risk wrote on Sunday that he expects the current recovery to continue for years yet.

I think the most likely cause of the next recession will be Fed tightening to combat inflation sometime in the future - and residential investment (housing starts, new home sales) will probably turn down well in advance of the recession. In other words, I expect the next recession to be a more normal economic downturn - and I don't expect a recession for a few years.

Interestingly, although McBride lists a number of possible causes of recession, a rate rise that is NOT engineered by the Fed is not among even the remote possibilities (which include pandemics and meteorite impacts). The Fed is, of course, very powerful, but not omnipotent, and overlooking the possibility that the Fed loses control of rates might turn out to be a significant oversight.

I am not suggesting a recession is imminent; there is no evidence for that. However I do think complacency, i.e. infinite faith in the Fed, is misplaced. So here is a negative scenario worth keeping an eye on:

Currently very low rates mean many low-quality companies are borrowing money they will probably not repay. And because many investors are searching for yield, a higher than normal proportion of investment dollars is going into poor quality debt (not unlike the early stages of the subprime boom). It would not take too much in the way of shocks from outside the country to cause a wave of defaults from CCC-rated companies, and this might then cause a rush out of junk bonds. If junk started to be repriced more rationally, one can imagine this spreading to corporate credits more generally. And if business credit started to dry up, that could well bring on a recession.

It is quite possible that free money will continue to support a recovery for some time. But in my view the recovery is strongly dependent on very low, highly irrational yields, and is therefore quite fragile.

Footnote on CCC issuance

There is not good public data on bond issuance in each rating class. However I continue to run across anecdotal evidence that the lowest rated debt is attracting excessive funding. Here, for example, from TCW last fall:

Underwriting standards have deteriorated recently as CCC and PIK toggle new issues both increased substantially in October. For the second month in a row, nearly $10 billion of CCC new issues priced, also setting an annual record and pushing CCC new issuance to 16% of the total volume for 2012. Over the last two months, CCC issuance has comprised approximately 23% of gross issuance and 24% of net issuance. PIK Toggle issuance also increased to 6.8% of gross issuance as dividend HoldCo transactions increased in frequency. This compares to 2007, a year of poor underwriting, when CCC issuance was 24% (45% net) and PIK toggle issuance was 10.5% of gross transaction volume.