Unlike in past business cycles, investors should not necessarily prioritise credit as a means to reintroduce risk into their portfolios, says Tina Fong, Strategist at Schroders.
Never in history has a US recession been more anticipated than in this business cycle. While the Federal Reserve (Fed) is pulling out all the stops to cool inflation, the US economy has surpassed expectations and performed resiliently. Despite this, we remain in the camp of those expecting a US recession to occur this year. So, if we are correct in our analysis, it begs the question what will the consequences of recession be for the main risk assets of corporate bonds, or credit, and equities?
Risk assets aren’t discounting a recession
As economic growth slows, investors become more concerned about the risk of corporate defaults. To take on this extra risk, they demand higher yields on corporate bonds, which causes credit spreads to widen versus government bonds. The implications of default are particularly relevant to corporate bonds, which are generally less liquid than equities and harder to offload during periods of market turmoil.
At present, both the equity and credit markets are signalling a low probability of a recession, based on high-yield bond spreads or the US equity risk premium, or total returns for these markets. This is an improvement on last year when the sell-off in equity and credit markets meant that recession probabilities surged to levels indicative of a recession.
Credit tends to move before equities during recessions
Historically, equities have tended to be late to the sell-off compared to credit in the run-up to recessions. Equities also tend to bottom out and recover earlier. One possible explanation for why equities tend to bottom out later than corporate bonds is that credit markets are generally more sensitive to shifts in the economic cycle and the potential for corporate defaults. Credit is also typically less liquid than equity markets, which may mean investors are more likely to unwind their credit positions earlier than their equity investments.
Corporate balance sheets are in a strong position
Despite the recent banking turmoil, tighter financial conditions and the deterioration in the growth picture this year, credit spreads have barely widened. This could be attributed to a couple of factors.
- Firstly, there is no impending maturity wall as a relatively small proportion of corporate bonds are due to be repaid or refinanced in the next couple of years.
- Secondly, the balance sheets of companies are coming from a strong position with healthy cash to asset and debt ratios. While the ability of companies to service their debt obligations, known as the interest coverage ratio, has fallen recently, corporates still have plenty of room to cover their interest payments. In particular, the interest coverage ratio of nonfinancial companies is close to record highs.
But the aggressive increase of interest rates by the Fed has led to cracks appearing. Interest expense growth has significantly risen such that it is now at the highest level since the GFC (chart 6). This is expected to put pressure on the interest coverage of companies, as higher interest payments are likely to coincide with the contraction in earnings from a recession. We are already seeing earnings growth and corporate margins ease from peak levels.
So, as the US economy enters a recession later this year, there is a possibility of spread widening prompted by a deterioration in fundamentals. But the strong starting point for corporate bonds may result in a less severe impact on the market compared to previous cycles. Whether credit markets will bottom and recover before equities during the recession remains to be seen but is likely to be dependent on the path of interest rates.
Every recession is different, and it is hard to time recessions, but we expect an US recession to occur in the fourth quarter of this year and the first quarter of next year. Besides being a relatively short recession, the contraction in economic growth is assumed to be modest compared to past recessions. With the Fed expected to cut interest rates in December this year, a few months before the end of the recession, it may mean that there is less of a timing difference in the bottoming and recovery of both credit and equity markets.
At the same time, the strong position of corporate balance sheets may mean that spreads don’t widen as much, which could also mean that they will be relatively less attractive when markets re-rate. Overall, the recession playbook between credit and equities may be different this time around. Investors may not necessarily prioritise credit as a means to add risk in their portfolio, as has been the case in past cycles.
Further reading : Has the credit versus equities recession playbook changed? by Tina Fong, Strategist at Schroders.