- Analysis from Morgan Stanley shows an asymmetric relationship in how corporate bond yields affect the economy.
- When US corporate bond yields widen, economic growth slows. But when they narrow it has little or no effect.
- Warning signs continue to flash that after years of gorging on cheap debt, more companies are now vulnerable as global interest rates start to rise.
Here’s an interesting observation about corporate debt: It doesn’t really boost the economy when the cost of debt is cheap, but it can be a significant drag when liquidity tightens and yields rise.
And that asymmetric relationship creates downside risks for the US economy as the Federal Reserve continues on its rate hiking path, Morgan Stanley says.
This chart shows the spread between BBB-rated US corporate debt benchmark US 10-year treasuries has been rising steadily this year:
Morgan Stanley said policy makers at the US Fed are now “paying close attention” to corporate debt levels, which have reached a record high 46% of US GDP.
They highlighted comments from the Fed’s financial stability chief Lael Brainard, who said the buildup of corporate debt has left more companies vulnerable to negative shocks.
“We interpret this to mean that policymakers believe that easy corporate credit conditions are supportive for activity today, but the unwind could generate even larger downside risks over the medium-term,” the analysts said.
To test the viewpoint, the analysts ran some regression analysis for periods when credit spreads narrow, and when they widen. They then matched that against US economic performance over the following six months.
The results? For every “sustained widening” of 10 basis points (0.1%), GDP growth falls by 0.3% in the following six months.
However, “for the same narrowing in credit spreads, the effect on GDP growth is roughly zero”.
Morgan Stanley noted that their analysis is relatively simplified, because there are a whole host of input variables which can affect economic growth.
However, “the emphasis of the analysis above is to show the asymmetric impacts on economic activity from corporate credit developments”.
If spreads do continue to widen, it remains to be seen which companies will be caught swimming naked when the tide goes out.
But more leading analysts are highlighting corporate debt as a key risk for the global economy. Three examples:
- Anton Pil, the head of JPMorgan’s $US100 billion alternatives investment arm, notes private credit markets have “exploded in size” since 2007, with a sharp increase in the issuance of “covenant-lite” loans which offer minimal protection to creditors.
- The latest BAML fund manager survey shows more global asset managers think corporate bonds will be the worst performing asset class in 2019. More respondents also want to see companies allocate capital to strengthening their balance sheet.
- Billionaire hedge fund manager Paul Tudor Jones said rising rates are “going to stress test our whole corporate credit market for the first time” in almost 10 years, and said the end of that run is going to cause a lot of difficulty for policy makers.
For now, Morgan Stanley said the Federal Reserve still views US financial conditions as relatively supportive.
So in that sense, the recent increases in benchmark interest rates have merely reduce some upside risk, rather than sparking fears of a crash.
“Further tightening in financial conditions may be warranted before these development have material implications for Fed policymakers,” Morgan Stanley said.