There has been growing consternation about the threat of a major meltdown in corporate debt. The Fed, in particular, has been very troubled by the amount of corporate debt in the economy, which has led to speculation by Wall Street that there could be a blow up. Goldman Sachs has been more sanguine, saying debt levels look healthy. Now the Fed appears to be taking a more mild view as well. In a speech this week, Chairman Powell said that the comparison to pre-Crisis debt levels are not convincing. “Most importantly, the financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages.
FINSUM: Debt levels seems high, but profits are margins are good to. The question is what happens when the economy turns south. We are especially concerned about the BBB market.
Between the escalating trade war and weakening data, the economic outlook is darkening. Accordingly, the market is increasingly betting that the Fed will cut rates. The market is now pricing a 50%+ chance of a 25 bp rate cut by the end of the year. Additionally, the yield curve, which is once again inverted, is signaling future rate cuts.
FINSUM: If Trump keeps escalating the trade war with China, he will force the Fed to do exactly what he hopes—cut rates! Really though, the odds of a rate cut are rising as the trade war looks like an ever bigger headwind to growth.
The Fed has a big new worry that is not presently on the market’s radar. With all the worries about headline economic data and the trade war, very little attention has been paid to the potential shock equities and bonds may feel from climate change. The Fed, however, is very focused on the risk. The Fed says that climate change can have a jarring effect on the economy that may “affect national economic output and employment”. “As such, these events may affect economic conditions, which we take into account in our assessment of the outlook for the economy”, says Fed Chairman Powell.
FINSUM: Calculating climate risk is tough because it can have short-term effects, but also much longer and more challenging ones, such as migration and agricultural output. That said, no one is expecting a climate change-induced financial crisis.
Investors are currently worried about corporate bonds. On the one hand performance has been pretty good, especially for the riskiest bonds. But therein lays the problem—highly indebted companies have not been punished and there appears to be way too much corporate debt at the moment. This is the Fed’s view and many market participants, but Goldman has shared another—that the amount of corporate debt in the economy is just fine and corporate balance sheets look healthy. The bank says US companies are in an “unusually healthy position this deep into a business cycle expansion”. Goldman notes that companies are spending a smaller share share of their cash flow on interest than they were a decade ago, and that they are earning more than they are spending.
FINSUM: The corporate debt situation is all about perspective. Things look better than in the last crisis, but anyway you slice it, the debt burden looks at least somewhat daunting.
One of the most famous names in bonds, Jeffrey Gundlach, has just put out a bold statement. Gundlach thinks there is forthcoming trouble in markets and he thinks it is the Fed’s fault. Specifically, Gundlach thinks the bond market is set for a lot of volatility. “interest rates cannot maintain the low volatility they have maintained over the last eight years”. To be clear, Gundlach is not calling for a recession, but says “But I am starting to think it is much less of a lock that there won’t be a recession before the next recession”.
FINSUM: There are two conflicting ideologies here. The Fed thinks volatility is largely an extension of the economy and policy, both of which it feels it can control to an extent. Gundlach and many other investors think there are underlying forces in the economy and markets that can only be pacified for so long. We think they are both right to an extent.