18 Jun Spoiler Alert (Q2-18)
The smart money, according to S&P Global, is gearing up for a downturn. The longest credit cycle since 1985 is in extra time and there are many signals, outside of the internal credit market fundamentals that we have revealed in previous letters, which justify high risk aversion and capital preservation. Peaking earnings, a flattening yield curve, and U.S. trade policy are threatening to spoil the (over)extended run in the credit cycle.
Operating margins for companies in the S&P500 have reached twenty-five year highs, fueled largely by tax cuts. However, wage growth has lagged and lack of human, not capital, resources has become the top constraint for businesses in both Canada and the U.S., suggesting labour prices have lots of room to run. BCA Research’s Margin Proxy indicator, which tracks the ratio of selling prices for the non-financial corporate sector to unit labour costs, appears to have peaked. Similarly, nominal GDP growth minus aggregate wages is trending lower reaching levels that coincided with previous recessions. The turn in corporate profit margins is worrisome in an environment when bond yields are headed higher. More reason for caution by credit managers.
The flattening U.S. yield curve is also troubling. The spread between the 2-year and 10-year yield is at just 25 basis points, close to its lowest since 2007. With increasing odds of at least two more rate hikes by the Fed, an inverted yield curve looks to be imminent and could curtail lending by banks affected by the consequent compression in net interest margins. As Grant’s Interest Rate Observer recently reminded its readers, an inverted yield has historically had ominous implications for economic growth. A flattening and then inversion of the yield curve in the U.S. has preceded every global recession since the 1970s. It would not be surprising to see the “smart money” begin to reduce risk exposure in anticipation of an inversion and hasten a downturn.in the economy.
Judging by the change in spreads, the implications from trade uncertainty have not yet been fully discounted by corporate bond markets. On March 1, 2018, U.S. President Donald Trump announced tariffs on steel and aluminum, and followed up in the same month with tariffs on US$50 Billion worth of Chinese goods including components used by aeronautics, technology, and materials companies. China retaliated with new tariffs on various U.S. food products and automobiles and their components. Since then, based on specific industry high-yield bond indices published by ICE, the industries that investors believe will be most negatively directly affected by a trade war were automotive, services, building materials, and food and beverage. Surprisingly, spreads on junk bonds in the aerospace and technology sectors actually narrowed. It seems that investors are willing to shrug-off the contractionary impact of a trade war as just as another buying opportunity. This is a mistake.
Today’s supply chains are much more tightly integrated and global than they were in the past. According to the Global Value Chain Participation Rate published by the OECD, nearly every multinational company in the S&P500 is exposed to extensive supply chain networks. This means even industries that are not directly affected by rising tariffs will be impacted by the higher costs for imported goods passed along the supply chain. If a trade war becomes protracted, which is very possible given Trump’s nationalist and authoritarian tendencies and unconstrained government powers on trade, global GDP would decline, business confidence would fall along with capital spending, and prices for consumer and capital goods would rise. All of this combined with tighter monetary policy from the U.S. Federal Reserve means a recession or economic downturn would be virtually assured.
The ongoing importance of security selection over index exposure cannot be overstated. The threat posed to credit investors from a trade war is significant, particularly given already elevated bond prices, low spreads, and high leverage. TEC’s portfolio has relatively low direct exposure to global trade. Our largest loans are in the energy and software sectors, where production costs and sales are domestic in the case of the former, and business activity is independent of trade flows or global supply chain networks.
There is a growing number of risks, both internal and external, affecting private debt investors today. It is going to be sudden death for many of the uninitiated and unprepared lenders currently active in the market. “Smart money” institutional investors are increasingly focusing on private debt managers that have expertise in managing distressed and special situations, a quality difficult to find given the relative inexperience of most participants. The ability to successfully resolve problem loans must be a mandatory core competency for lenders; unfortunately, this only becomes apparent when the cycle turns, and losses suddenly occur.
 BLS June 2018 Labor Turnover; CFIB June 2018 Help Wanted