(Bloomberg) -- The post-election rally in corporate credit could stage a sharp reversal, warn analysts at Morgan Stanley.
Corporate credit's been on a tear since Trump's victory, as his proposed policies have fueled an upward shift in projections for U.S. growth and interest rates. Now the investment bank is arguing that tighter financial conditions in the form of rising interest rates and a stronger dollar, along with high leverage will conspire to gatecrash the party. They've looked at the positive market signals — inflows to bond funds, projections for lower default rates, and an uptick in estimates for corporate earnings — and found them to be over-hyped.
While investors are betting the rally in junk bonds still has juice even as the asset class delivered double-digit returns in 2016, fixed-income analysts led by Adam Richmond argue investors should reduce the credit risk of their portfolios and move back into high-quality government bonds. They are restating bearish projections issued at the end of November, when they forecast high-yield bonds would post a total return of minus-2.7 percent for 2017.
Since then markets have thrown caution to the wind with credit spreads rallying even as rising rates on higher-quality fixed income assets have, in theory, diminished the need to dive lower into the credit spectrum for yield. It's a rush to risk that's akin to the stock market rally, where earnings optimism has trumped a higher discount rate.
"Higher Treasury yields in an environment of high leverage have to matter at some point," the analysts wrote in a Jan. 6 note. Here are their five reasons for caution.
Stronger growth ≠ higher returns
Monetary conditions are more important for credit markets than “modestly better” growth, they say. With fiscal stimulus projected to kick in relatively late in the economic cycle and the labor market near full employment, tighter financial conditions — strong dollar, high rates — will offset the growth boost from looser budgetary policies, the analysts note.
Meanwhile, structural headwinds, such as heavy debt burdens and an aging population, loom large. “We think that the Fed withdrawing liquidity matters more than an extra couple of tenths of a percent on GDP growth, and creates an environment where negative catalysts will be magnified,'' they write.
The cycle is foreboding
The credit rally is in its late stages while valuations are rich, setting the stage for a fall in bond prices as the Federal Reserve tightens.
“Remember, the Fed is not beginning to withdraw liquidity early in a cycle, when the economy is booming, earnings growth is strong, and corporate balance sheet quality is pristine. These hikes are coming in the eighth year of an expansion, with growth sub-2%, leverage at record levels, and when markets have been arguably more dependent than ever on that central bank support. As we have seen over the course of this cycle, withdrawing liquidity in this environment means mistakes are more likely, negative catalysts are magnified, and, with valuations at current levels, there is a much smaller margin of error.”
Morgan Stanley
Lower default risks ≠ spread tightening
Credit markets are forward-looking and spreads in a given year reflect, in part, the change in projections for defaults in the following year, the bank argues. If defaults stage an uptick in 2018, markets may price in that prospect in the second half of the year, placing pressure on spreads. With U.S. corporate leverage at a record high on some metrics, default risks are set to spread beyond the energy sector.
Higher earnings can't mask declining fundamentals
It's unlikely earnings growth can materially improve corporate balance sheets given high absolute debt burdens and rising rates. Meanwhile, the incentives for firms to continue gorging on debt are high amid expanding U.S. output — a negative cocktail for spreads.
"Expecting companies to de-lever balance sheets in an environment where growth and animal spirits are both improving is wishful thinking, in our view. At least that's not how it usually works."
Counter-intuitively, even if credit markets see decent inflows — defying projections of a great rotation out of fixed-income funds in favor of equities — there's no guarantee spreads will tighten since the former often represents a lagging indicator for where the market is headed, the analysts caution.
In short, strong flows usually tell you that spreads have tightened, not that spreads will tighten. We think that, more often than not, very weak technicals are a signal of an oversold market (i.e., this past February) and periods of strong flows (June '14, Oct '14, Apr '15, Oct '15) are often good times to lighten up on risk. And at the end of the day, while flows may matter in the short term, we think they matter a lot less the further out in time you go.
Morgan Stanley
To contact the author of this story: Sid Verma in London at sverma100@bloomberg.net.
To contact the editor responsible for this story: Jeremy Herron at jherron8@bloomberg.net.
