US investment-grade outlook stays solid despite firming recession fears
While US economic data continue to be resilient, higher energy prices and rising long-term interest rates increase the probability of a US recession in 2024. But even if the outlook weakens, the lingering impact of super-normal liquidity and a structurally tight labour market from the pandemic period could be enough to maintain the function and appeal of the US bond market to global issuers.
Kathryn Lee Senior Staff Writer KANGANEWS
When the US economy catches a cold, it is not so much that the rest of the world sneezes as that it hunkers down for what will more than likely be an epidemic. But despite the likelihood of a US recession next year, there is also reason to believe the local investment-grade credit market will stay resilient. So says Tom Joyce, New York-based managing director and capital markets strategist at MUFG Securities, who visited Australia in September 2023.
The US market could be increasingly discriminating but many Australian corporates may find it still meets them with open arms, suggests Joyce. He says Australian issuers should find they have access to deep, liquid and resilient US dollar credit markets , despite slowing global growth, elevated energy prices, sticky services inflation and central banks tightening policy at the fastest rate in four decades.
"A US Treasury bill that yields 5 per cent is already attractive, but a single-or double-A rated Australian corporate with a strong balance sheet that offers more yield will undoubtedly appeal to investors," Joyce comments.
While 2023 US dollar corporate bond supply has been strong, the recent rise in US Treasury yields has begun to dampen the pace of issuance. In September, the US investment-grade market surpassed US$1 trillion of total year-to-date issuance. This is a somewhat later achievement of this milestone than the previous two years, but the full-year forecast lands primary supply right in between 2020 and 2021.
Joyce is confident in the stock of global real money seeking income-producing assets. He tells KangaNews: "There is a much larger and wealthier global middle class today, and it is ageing. This has resulted in a surge in yield-seeking global assets under management. If we add up pension funds, insurance funds, asset managers, sovereign wealth funds and money-market funds, there is more than US$200 trillion looking for strong balance sheets."
Sovereign bonds are the natural choice for a large proportion of these funds but, according to Joyce, high-rated corporates are an important part of the mix. "Well-managed, global multinational corporations are in some ways even more attractive than government bonds. They have built fortress balance sheets during COVID-19, have robust earnings streams and offer incremental yield," he adds.
“The pandemic-era savings number is probably close to zero by now. Consumer spending remains strong but evidence of weakening has begun to emerge. It is to be expected when the Fed tightens that there will be a lag. It typically takes 12-18 months in the US. But we are starting to see the bite of the tightening.”Button Text
This does not mean the economic outlook has no impact on the credit market. Joyce has visited nearly two dozen countries across Asia, Europe and North America over the past 18 months, primarily meeting with companies that issue in the US dollar bond market. He met KangaNews on the Australian leg of this Odyssey. Joyce says he has heard the same question wherever he goes: borrowers ask about the risk of recession in the US and the implications for the global economy.
The battle to control inflation is ongoing, and the fast pace of rate hikes by the US Federal Reserve (Fed) and others is having the predictable slowing impact on economies. A major complicating factor is that post-pandemic structural imbalances are causing the economic cycle to behave in a less predictable manner. For instance, Joyce notes that credit spreads have tightened in 2023 even as no fewer than 85 central banks around the world have gone through significant tightening cycles.
"The market is optimistic that the US economy and the Fed can withstand the increases in interest rates," Joyce explains. "The economy is actually performing fairly well, even though many had thought the US economy would go into recession some time in the early half of 2023."
Whether this relatively benign performance will hold is a matter for debate though Joyce says the consensus view is starting to coalesce around expectations of a mild US recession in early 2024. His own outlook suggests the case for a hard landing is more likely than a more benign outcome although he acknowledges factors on both sides of the ledger (see table). Joyce concludes: "It would be unprecedented in modern economic history for the Fed to tighten this much and the economy not to go into recession."
|FACTORS SUPPORTING US SOFT LANDING||FACTORS SUPPORTING US RECESSION|
Structurally tight labour market
|Accelerated tightening cycle|
Strength of balance sheets
|Higher energy prices|
|Structural housing market undersupply||Inverted yield curve|
|Rapid progress on inflation||Significantly tighter bank lending|
Strong services sector
Depletion of consumers’ COVID-19 savings
Bank sector stablisation
Manufacturing and corporate earnings recession underway
Mature credit default cycle
Source: MUFG Securities September 2023
The Fed has lifted its policy rate by 5.25 per cent since it commenced the cycle in 2022. Adding to tighter policy and unlike its EU or Australian peers it has also been actively unwinding holdings accumulated in by QE programmes, reducing the size of its balance sheet by US$826 billion in total or about US$95 billion a month. "The US Treasury has issued more than US$1.3 trillion since the 1 June debt ceiling resolution at exactly the same time that the largest buyer in the market is reducing its balance sheet," Joyce notes.
The challenge in the US is the less direct transmission mechanism of central bank policy to the household sector, given the high preponderance of long-term fixed rates in the mortgage market. Joyce is confident, however, that tightening is having a significant impact. Wage inflation is still running higher than price inflation and unemployment has stayed lower than 4 per cent for nearly two years.
But US households have depleted all their "excess" pandemic-era savings and loan defaults are starting to climb. The savings buffer was particularly significant as it supported the household sector during the highest inflationary period in four decades. Joyce points out that the US$2 trillion of additional savings accumulated during the two-year pandemic period is more than the GDP of all but 10 world economies. The decumulation is almost as startling, however: in September, the San Francisco Federal Reserve estimated that the pandemic additional savings pool had dwindled to approximately US$190 billion by the end of June.
"We think the pandemic-era savings number is probably close to zero by now, Joyce suggests. Consumer spending remains strong but evidence of weakening has begun to emerge. It is to be expected when the Fed or any central bank tightens that there will be a lag. It typically takes 12-18 months in the US. But we are starting to see the bite of the tightening."
FUNDING MARKET IMPACT
Tighter policy settings have already had a significant impact on the cost of debt. Joyce notes that average yield on investment-grade debt in the US was around 5.8 per cent in September. When central banks were pumping the system with money to support the economy, rates and credit spreads fell so low that the equivalent figure was just 2.1 per cent.
Typically, a slowing economy in a tightening cycle should mean the rates and credit spread component of funding cost are both higher, the latter driven by growing investor fears of issuer default. Central bank response to recession, in the form of rate cuts, is the eventual corrective. The risk at this stage is that sticky inflation causes the Fed to stay higher for longer or even to hike further thus extending the stage of elevated funding cost.
However, Joyce believes investment-grade credit will remain strong in the months ahead as corporate balance sheets are typically robust and many borrowers took the opportunity to set their funding during the long period of very low rates. "They moved quickly to issue a lot of low-cost debt and also to extend maturity profile," he says. "Credit spreads for corporates may not widen in this recession as much as they typically do."
Joyce's attention will be focused elsewhere in the corporate funding space. "The investment-grade market will continue to perform," he says. "But high-yield spread widening could be significant if long-term US Treasury yields remain higher than 5 per cent for a sustained period." As the cycle progresses, he adds, spreads are likely to widen though perhaps less than in prior recessionary periods.