Risk On…For Now

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It’s a good time to be an investor. In what, you ask? Pretty much anything at this point. Global industrial production is cranking away at close to fullspeed, and Credit Suisse economists expect global economic growth to increase from an estimated 3 percent this year to 3.8 percent in 2014. Even the beleaguered euro zone is experiencing strong manufacturing growth and should finally see its economy expand in 2014 after two years of contraction.

 

Central banks are doing their part, too. Monetary policy is extremely loose, with near-zero interest rates at every one of the Big 4 central banks – the Federal Reserve, European Central Bank, Bank of Japan and Bank of England. The Bank of Japan and Federal Reserve are both continuing with their unprecedented and massive monetary stimulus programs, while the European Central Bank has been assuring markets it is prepared to ease further, if necessary, by extending additional long-term loans to troubled banks and potentially even introducing negative deposit rates. And so here we are, in the sweet spot—the threat of economic collapse has passed while the prospect of inflation is still a distant concern—and the flood of money is having the expected effect: “Financial assets – safe and risky, developed and emerging, bonds and stocks, have found their groove and are posting strong returns,” Credit Suisse’s global strategists wrote in a recent note called “Momentary Bliss.”

 

But there’s the hitch: “momentary.” Indeed, the current rally could start to fade as early as the beginning of 2014, says James Sweeney, a global fixed income strategist at Credit Suisse. While he and his colleagues predict a soft landing in most markets, rather than a crash, they are predicting a landing nonetheless. Which will lose altitude first? For an answer to that question, one need only look to the summer scare. After the Federal Reserve said in May that it might slow down its monthly asset purchases later in the year, investors dumped emerging market stocks and bonds in a panic. At the same time, they briefly started demanding higher yields from less creditworthy borrowers in developed markets. Investors reversed course when the Fed backed off the “taper talk,” but the incident does suggest that any impending pullback will likely show up in relatively risky assets first.

 

Credit Markets Surge

 

And in the meantime? The near-zero interest rates that major central banks have been enforcing for the last few years have been great for U.S. corporate borrowers. Whether in leveraged loans or high-yield bonds, investors have eagerly sought out riskier assets in search of decent returns. In doing so, they’ve driven down yields of even the lowest-rated corporate bonds while also accepting less onerous terms in leveraged loan deals than at any time in recent memory

 

The U.S. leveraged loan market is on pace to hit a new record of $450 billion in issuance this year, well above the record-breaking $387 billion that came to market in 2007, Credit Suisse’s Co-Head of U.S. Syndicated Loan Capital Markets Jeff Cohen said on a recent call with investors. Retail investors have plowed money into leveraged loan funds (both mutual funds and exchange-traded ones) for 71 weeks in a row, adding a net $45.8 billion so far this year. While nearly a third of the money raised—some 29 percent—has been used for strategic purposes such as mergers and acquisitions, a much larger portion—47 percent of the total—has gone toward refinancing. Meanwhile, 11 percent of leveraged loans this year were dividend recapitalizations. Bondholders aren’t usually wild about borrowers taking on debt just so they can turn around and give it to equity holders, but by September, enough dividend-related loans had been completed to make 2013 a record year. “Investors are basically going along with whatever issuers want even if the use of proceeds is not ideal,” Cohen said.

 

Another sign of the market’s risk cravings? Along with that increase in loans has come a decrease in investor protections, including fewer restrictions on collateral as well as more lenient debt-to-cash flow ratios. Borrowers have nabbed some $210 billion in covenant-lite loans this year, more than double the $87 billion issued in all of 2012. Most deals of more than $50 million are now covenant-lite, according to Cohen, who called them “the new standard.”

 

And finally, there are high-yield bonds – which, thanks to plenty of investor interest this year, don’t actually have particularly high yields. The Credit Suisse High Yield Index, which tracks the “spread to worst,” or the difference between the lowest-yielding high-yield bonds and Treasuries, has hovered between 4.4 percent and 5.5 percent this year, even as investors were in a momentary panic over Fed tapering. That compares to levels in excess of 18 percent at the height of the recession in 2008, and even 8 percent as recently as 2011. This year’s nearly $300 billion in high-yield issuance is on pace to break all records save perhaps the $346.9 billion issued last year, according to Credit Suisse’s Head of Global Leveraged Finance Strategy Jonathan Blau. While some of those bonds helped refinance existing corporate debt, there was new issuance, too: the total market grew by 5 percent, Blau said.

Source: Credit Suisse Macro Call, Oct. 28, 2013

Source: Credit Suisse Macro Call, Oct. 28, 2013

Winds of Change

 

So what are the potential catalysts for another change in the market’s mood? For its part, Sweeney’s fixed income strategy team keeps a close eye on the rate of change in global industrial production. Lately, it’s been accelerating and fueling investor confidence, but the team expects momentum to peak in December. That doesn’t mean factory production will fall off a cliff in 2014 – it’ll just grow less slowly — but nobody likes riding a trend downhill. “At momentum peaks, negative economic and earnings surprises tend to occur, driving risk appetites lower,” Sweeney said on a recent investor call.

 

And then there’s the issue that has troubled global financial markets for the last six months – tapering, or a slowdown in the $85 billion in monthly asset purchases the Federal Reserve has been making to keep interest rates low and economic growth humming. Thus far, Sweeney pointed out, U.S. growth has been just sluggish enough to keep central bankers from dialing down QE3. In part due to a gap in data collection caused by the government shutdown, which has only complicated the already-challenging task of parsing the clues about the economy’s health, it’s unlikely that Fed officials will choose the remaining meeting of this year as the time to start tapering. What’s more, Sweeney says, Janet Yellen’s recent appointment as central-banker-in-chief is bolstering risk appetites for now, as she is perceived as relatively dovish.

 

That said, with the U.S. economy expected to grow 2.5 percent in the first quarter of 2014 – far better than the 1.1 percent in Q1 2013 – Credit Suisse believes officials may be able to judge the patient healthy enough to get reduced medication by the end of the first quarter. Credit Suisse’s chief Fedwatcher Dana Saporta believes the Fed could start reducing the central bank’s asset purchases as soon as late January and wind up the program altogether by September. Markets have already gotten a taste of what that might feel like. A recent Fed survey of institutions that sell dollar-denominated securities showed that liquidity seized up after central bank officials first talked about phasing out the asset purchase in May. “Renewed taper talk and rising rates would risk another illiquidity flare-up in credit markets,” the fixed income team wrote in its “Momentary Bliss” note. And if that happens, investors and issuers alike will find themselves reining in their current enthusiasm. “Some of this bullish positioning we’re seeing right now will at least temporarily be interrupted,” Sweeney said. In other words, while there may not be a need for disaster planning quite yet, the risk-all-the-way on trade might soon have run its course.

 

Photo by Songquan Deng courtesy of Shutterstock.com. 

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