Credit markets have experienced gradual but steady weakness for nearly six quarters, with investment grade and high yield spreads widening by 52bps and 277bps respectively since June 2014.1 [Exhibit 1] Underperformance was initially concentrated in the high yield energy sector, caused by the rapid collapse in oil prices, but it has later spread into the rest of the credit universe.
Despite cheapening valuations, this significant market move has been worrisome and has led us to pause for some time and focus our attention to credit fundamentals. Fast forwarding to today, economic fundamentals over the course of 2015 have moved in the wrong direction, validating rather than confuting the behavior of credit spreads. So, what changed? Where are we in the credit cycle?
While interest rates remain at historically low levels, a substantial tightening in financial conditions has occurred via a 15% appreciation in the U.S. dollar against its largest trading partners. While this outperformance is a reflection of the relative strength of the U.S. economy, it provides substantial headwinds to future domestic and international growth, given its drag on U.S. exports and the tightening in financial conditions for global dollar-denominated credit markets. In other words, despite a steep yield curve in U.S. Government bonds, and no hikes by the Federal Reserve, we believe overall monetary conditions have already become tighter.
In addition, credit fundamentals have also deteriorated in the past few quarters, as evidenced by the meaningful buildup in aggregate corporate leverage, which is now running at cyclical highs. [Exhibit 2] While leverage is not itself the catalyst of credit underperformance, it does signal rising vulnerabilities in the corporate sector, which is becoming increasingly dependent on revenue growth and debt rollover. This is where we are becoming more cautious. As discussed in previous blogs, we believe the U.S. economy is in an early “slowdown phase” of its business cycle2, where historically profit margins peak and revenue growth decelerates. Finally, as illustrated in the chart below, we are currently experiencing the first tightening in lending standards since 2011.
Back then, loan officers were temporarily shaken by the European debt crisis, and quickly reverted back into easing conditions. Today, the historical correlation between the debt cycle and lending standards suggests banks are becoming increasingly cautious about aggregate leverage, with potentially further tightening in lending standards going forward. This would be a negative outcome for future credit returns.
In our opinion, recent developments in macro and credit fundamentals warrant a more defensive asset allocation stance. We believe the best strategy is to move up in quality and shorten credit duration, while overweighting government bonds versus benchmark.
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1 Spread widening measured using the Barclays U.S. Aggregate Credit Index and the Barclays U.S. Corporate High Yield Index as of 11/20/15.↩
2 For more details on our macro regimes framework see our white paper on “Dynamic Asset Allocation through the Business Cycle – A Macro Regime Approach”.↩
The Barclays U.S. Aggregate Credit Index is an index of U.S. Government and corporate bonds that includes reinvestment of dividends. The Barclays U.S. Corporate High Yield Bond Index covers the universe of fixed rate, non-investment grade debt.
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These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.