Interpreting the COVID “Shock” and Policy “Awe”
April 21, 2020
Rich Consul: Thank you for joining the Incore Capital Management fixed income insights for the third quarter of 2019. My name is Richard Consul, I'm a Senior Portfolio Manager on the Incore team. The title of our presentation is The Economic Check “Engine Light Blinks” Yellow.
Overall, our perspective on the market can be broken out into macro, corporate, and monetary policy perspectives. From the macro perspective we still see strong consumer demand, but the problem is this weakening global manufacturing and an inverted yield curve are working to slow the economic engine. As we looked at kind of like what is underneath the covers a little bit here, GDP estimates are indicative of slower growth through the remainder of 2019 however US job growth and raising wages are supportive of the personal consumption side of the equation, which is as we know 70% of US economic growth. The problem is global and US PMIs are indicative of slower manufacturing output.
From a corporate credit view, intermediate triple B corporate credit spreads or near the low end of their historic range and leverage remains elevated. Debt continues to exceed EBITDA growth, which is really a real concern as that's an indication of weakening corporate credit. Triple B issuers are focused on balance sheet improvement to maintain their IG credit rating. It's good that they're making this improvement at this stage but the leverage in triple B's is quite high historically speaking.
From a monetary policy perspective, FLMC is signaling the next move in rates is lower and I think this is very, very important and we're going to get into later in the presentation. But what the FLMC is doing and needs to do is really un-invert the yield curve. In versions of the yield curve basically are nothing more than kind of a parking brake on the economic engine of the car. You know, decreases leverage incentive. Yield curve inversions typically precede recessions by four quarters because of this kind of driving with a break thought process.
So, as we get into some of the more detailed analysis of what's going on in the economy, we can see on this chart is real GDP by component contribution going back to 2014, and it breaks out GDP into its five kind of core elements the way we look at it. Personal consumption, business fixed investment, inventory change, net export activity, and government spending. And what we can see in the second quarter, all the way to the right there is that red area which is indicative of personal consumption remains strong. And I like to point out that the personal consumption reading that we saw in the second quarter is the third highest reading since 2014. This is a very, very robust consumer driven economy right now. But you can see we now have three negative contributors of the five factors leading to kind of slower growth.
The green being business fixed investment activity, purple being inventory change and blue being net export activity. The strong dollar is really, really weighing on negative exports right now for the US economy and that is a real concern especially as we look at some of these trade war issues that are going on. The highlight is really this chart and what this chart looks at is the jolts job opening survey versus unemployed workers in the labor force. And you can see we've got this chart going all the way back to early 2000 and the blue line is job openings and the orange line is unemployed. And as you can see for the last 19 consecutive months we've been in a situation where US job openings are actually greater than unemployed workforce. And when we think about what really drives consumer demand it's really three functions. It's do I believe and have confidence in my job? If I'm not happy and I don't have confidence in my job, is there a suitable alternative to my job? And number three, do I have a reasonable expectation of making more money tomorrow than I do today?
And really this chart encapsulates and captures all of that in one. If you are happy with your job, obviously you don't want to change jobs, but if you're unhappy with your job, what we are seeing right now is we have plenty of job openings and there's companies willing and interested in hiring qualified individuals and that's motivating people to A, quit jobs and change over, and we're seeing that in the quits ratio, but it's also driving a wages upward. And as we know, payroll growth and wage growth has been on the higher side of the last 15 years.
So, these are all really good inputs into what really drives the consumer, which is job growth and job and earnings growth. The problem is this, this chart looks at manufacturing PMIs from December of '17 to the latest end of September of 2019. And what we can see is back in 2017 all the way at the bottom there you'll see global PMI was 54.4. Anything over 50 years is a sign of expansion. Anything sub 50 a sign of kind of contraction in the manufacturing area of the global economy. At the end of '17 we were at 54.4. Right now, globally, we are actually in contractionary territory and that is the great concern. It doesn't concern the United States as much as it does the rest of the world because manufacturing is a much smaller portion of our economy, but as you can see in Europe specifically Germany where exports are 39% of their other economic engine, this manufacturing slowdown is really, really having a direct impact not only in the Eurozone but across Asia as well, and that is a very, very big concern.
The two main kind of indicators that people look to for indications of not only a slower economic growth but really recessionary indicators are the inversion of the yield curve and these numbers right here, PMI and with now the global number in contractionary space this is a very big kind of blinking yellow, maybe even red light of just how bad the slowdown in global growth has gotten.
What this chart looks at is the relationship that we were just talking about, which is the relationship between PMI readings and GDP growth, specifically focused in the United States. And the blue line here going back to 1990s to where we are today, the blue line is ISM and the orange line is GDP, and you can see that there's a very, very strong relationship in the directionality of both ISM and US GDP, and what you can see there on the far right hand side is kind of where we are right now, which is ISM manufacturing readings have really fallen off quite substantially, and as we kind of see from this chart, there is directionality indication from where we would expect to see US GDP growth go as well. And this is what we need to figure out, because if this slow down continues to pick up speed from here to the downside, this could be the core driver behind a US recession.
Now, we don't think that that's going to be the case, but it is something that we're concerned out of in that hence the reason why we look at the economic indicators showing in blinking yellow on the economic car here. We think we might've found a trough here at the bottom, but we're going to have to really follow this over the coming months to determine exactly what its true impact on US GDP could be in the quarters ahead, but it is a concern as we sit here today. So, we're going to pivot now to kind of the credit side, what's going on in the corporate side of the economic ledger. And one of the things that we look at very specifically is kind of what we're being compensated or how much additional yield over treasuries are we receiving as investors for being invested in triple B corporates. And what this chart looks at is intermediate triple B OAS. OAS is just a fancy term for what is the additional spread over treasuries that you get for being in corporate credit.
As you can see that orange line, we're at the near the lows, historically speaking, of the yield spread over treasuries for triple Bs. It's a big concern, right? Because as these pages previous showed, you know, manufacturing penalized flowing, we've got an inverted yield curve. And in that environment, there's a lot of concern about a slowing economy. But spreads right now would tend to be much wider given some of those concerns and they're just not. They're actually closer to the tights. So intermediate triple B corporate spreads or near the low end of the historic range. And this is a real concern for us and it's one of the main reasons from a positioning perspective we are now neutral intermediate corporates, specifically triple B's. And we've started to take kind of our overweighs and agency MDS where spreads are actually above historic average from a sector perspective.
But as we dive a little bit deeper into the credit metrics, because when you think about corporate credit, you know, obviously the economic landscape is very, very important to looking at credit. But it also has to look at the underlying fundamentals. And what these two charts help to kind of look at is what are those economic fundamentals underlying? And what we take away from this chart on the left hand side is leverage versus net growth. We can see that leverage is on the high side that we've seen this entire cycle. So corporate leverage is at the highest level that we've seen in generations, and the debt growth is actually continuing to pick up. Neither one of these two things is very good for corporate fundamentals, especially as an investor in corporate credit.
The chart on the right hand side though kind of tells a little bit different of a story, and you'll see the orange line is profit margin and the blue line is interest coverage. So, what we can see here is even though corporations have a lot of debt and a lot of leverage and they're actually growing that debt, what we can see is that corporate profit margins are at 29.5%. This chart goes back to 2013. If we were to take this chart going back 20 or 30 years, the current profit margin level, 29.5% is some of the highest corporate profit margins that we've seen in decades. Corporations might with this higher profit margin be able to sustain and maintain a higher leverage position.
The other part is because the interest rate environment is so low, you could see that interest coverage is on the low side. Both of those aspects are very positive. So, we've got negatives in aggregate leverage and debt growth, but we also have positives in the form of profit margin.
And the third thing that we're also seeing is strong demand for corporate bonds, and that's just providing this technical headwind and supportive of continued tight triple B spreads. Now when we also look at credit, we want to be looking at kind of triple B credit versus say A credit rating, because towards the end of this cycle their behaviors tend to change. So, one of the things that you'll see on the left hand side is debt growth As versus triple Bs, and As are in orange and Bs are in blue. And what you'll notice is that A rated corporate credit, so the higher kind of quality corporate credit, are actually growing debt much faster than the triple B side of issuers. So, when we talk about debt growth kind of picking up, what we're seeing is that the debt growth is really on the A rated side and the triple Bs actually are slowing their debt growth much more significantly.
The other thing is that chart on the right hand side, which is what are companies doing with this additional leverage in this additional borrowing activity that they're taking on? And again, what we can see is that the earnings payout ratio for As versus triple Bs, A rated companies are tending to pay out more of their earnings in the form of share buybacks and dividends than triple Bs. Another way to kind of think of this is that triple B issuers are increasingly focused on balance sheet kind of maintenance or balance sheet improvement to maintain their IG credit rating. You usually do not see corporations curing their balance sheet late cycle, and what we're seeing right now is triple B companies tend to be curing their balance sheets late cycle before we've even gotten to a recession. That would be a very, very good signal. The only problem is leveraged is still very, very high, so there's a lot more curation that needs to occur here.
We're going to pivot now to monetary policy, and I think this is one of the most important things that really isn't getting enough kind of the limelight here. So, when we look at monetary policy, we can really kind of look at it in a lot of different ways, but high level the FLMC is signaling the next move in rates is lower. We believe October 30th they are going to lower rates by 25 basis points. It is our belief they should actually probably do it by 50 but because of how they've been talking and communicating with the market, it's more likely that we get 25 basis point cut in October with probably another 25 in December. One of the things that their policy has to really be geared at is steepening out the curve because if you can steep it out the curve, what you can do is sustain the expansion and maybe help move inflation towards that 2% policy target.
Well, some of the risk factors here are if the FLMC really remains divided in both the path and trajectory of future rates. We can see this in all the different fed speak and speeches that have occurred over the past month, month and a half year, where you've got half of the board that's basically saying, no, we don't need to cut rates. And there's other people on the board that say we need to go faster. So, the fed remains really divided. And I think this is really a big concern to the market because even though Powell may want and communicate the likelihood of trying to get a 25 basis point cut in October and December, there might be a fracture enough on the board to stop one of those cuts from going through, and that would really kind of be the stabilizing to the market and a real big consternation to the market.
One of the things we have to remember is that inverted yield curves decrease economic leverage. They disincentivize it, and when we decrease leverage in the economy, we decreased the monetary velocity of money and when we decrease monetary velocity of money, we decrease the long-term economic trajectory of growth. That is the real concern and the culprit of it is the inverted yield curve. Now we'll get into exactly the economics of that in the pages ahead. US China trade negotiations and global growth are key concerns, but really those two factors above are the biggest ones.
From macro perspective, one of the things that's really supportive of the continuation of the strong dollar is really what's going on, not only here but overseas. We've got the ECB, the Bank of China and the Bank of Japan are all now in fully accommodated policy mode. The ECB and China basically for all intensive purposes are competitive and de-valuing their currencies, both to offset the tariffs that have gone in place but also to be more competitive in the export marketplace. Both of those aspects are really putting downward pressure on inflation and we can see this in the numbers where import prices year over year are actually down at 1.8%. And given the fact that tariffs have gone up pretty much across the board on a number of goods, it's quite surprising to see import prices down 1.8% year over year, even factoring in the effect of those tariffs.
The last thing is negative interest rate policies now engulf nearly $17 trillion of debt globally. This is a real issue. How this plays out over the coming decade is going to be very, very interesting because negative interest rates, theoretically speaking, just don't make sense.
So, let's talk about why the inversion of the yield curve and yield curve shape impact leverage so much. You'll see on the left hand side I'm showing you the steep yield curve as we saw it at the end of 2016. At the end of the 2016 basically overnight rates were zero and a 10 year treasury was about 2.5%. And in the box below there you can see kind of the economic leverage equation. So, if you're earning on a 10 year bond, 2.5% and you're borrowing the overnight repo market at 0.125%, so basically nothing, you're getting a net gain of 2.3 and some change percent. Now if you're a bank that takes eight times leverage and you times that by eight you can start seeing how banks and shadow banking and hedge funds and players who use leverage in the marketplace basically in a steep yield curve environment are incentivized to actually take leverage up.
Now go to where we ended the third quarter of this year. And you can see the funky shape of that curve, right? The overnight rate basically is a 1.85% and the 10 year yield is 1.6, and essentially that yield differential of negative 20 basis points is one of the reasons where basically you're not being incentivized to take leverage. So, what happens is in a steep yield curve, you increase the incentives to actually increase leverage. When you invert the yield curve, you actually decrease the incentive and you actually thereby decrease economic leverage. What both of these do is when you decrease leverage, you slow economic growth, and it's one of the reasons why the inverted yield curve combined with some of the bank regulations are starting to cause some of the repo funding issues that we're seeing across the banking sector. And one of the reasons that the fed has basically had to start doing quantitative using for all intents and purposes.
So, as you can see from that previous page, you're not being incentivized as a bank or as a consumer to take leverage in a negative yield curve environment, inverted yield curve environment. When we go back to the last five times that an inverted yield curve has taken place, a recession follows between two to six quarters. On average, it's four quarters from that inversion. We've now been inverted since May of this year. This is a very, very big concern. If we take the average of four quarters, basically this indicator states that by May of next year we should be entering into the recession. Now the assumption here is that the fed doesn't take any additional steps to uninvert the curve, which is a big if, because the fed's already said they're going to possibly cut in October and December. So, what the fed really needs to focus their policy objectives on is uninverting the curve.
If they can uninvert the curve, given how strong the consumer is right now, we might be able to grow through this global manufacturing slow down. But that's a big if, it's a big if. So, we're going to be watching. As you go forward for this quarter you need to be watching the consumer. Consumer still looks strong, but you need to be watching them. You need to keep an eye on what's going on the manufacturing side and you need to be following what the fed is doing from a monetary policy perspective. Can they through cutting rates in October and December uninvert the curve? And if they can, we might be able to sustain this economic growth for another couple years here, because the consumer just looks that strong right now here in the United States.
Thank you very much for participating in our quarterly update. Again, my name is Richard Consul and if you have any questions, please call your Victory relationship manager who can put you through to us to ask any additional questions. Thank you and have a great day.