Reframing The Cycle Question

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by: Neuberger Berman

By Brad Tank, Chief Investment Officer - Fixed Income

However long the cycle has to go, it's not too early to favor quality and tighten up issuer selection in credit.

There is one question on just about every investor's lips right now: "How much longer can this credit cycle go on?"

Did we get a little more guidance from the Federal Reserve last week? The decision to drop the word "accommodative" from the description of current conditions got some attention. We also got our first look at the Fed's dots for 2021; however, the wording was a nuance, and the dots were so dispersed that they suggested little more than a soft landing in two years' time. The market response was mixed.

So the question persists - unsurprisingly, given we are now just months away from this cycle being the longest on record.

But maybe it's the wrong question to ask. Instead of when the cycle will end, maybe we should concern ourselves with what the cycle will look like when it does end, and whether some markets are priced as though it will never end at all.

That way, we can at least begin to prepare for some of the more likely outcomes.

Optimistic in Perpetuity

Let's start with the second question: Which markets are asking you to be optimistic in perpetuity?

For us, CCC-rated high yield would be on that list. We've also been arguing for a while that the wave of high-yield issuance moving from the bond to the tradable bank loan market has meaningfully eroded coupons, covenants, credit quality and seniority in loans - so we would add that to the list, too.

With loans looking frothy, it's no surprise to find private equity awash with late-cycle exuberance, too. Megadeals are back, multiples are at multiyear highs, seven turns of leverage are not uncommon. David Rubenstein, co-founder of the Carlyle Group (NASDAQ:CG), told a conference that it is easier to raise money than at any time in his 30-year career.

Even parts of investment grade call for rigorous credit discipline. The BBB sector has ballooned, and while that rating probably overstates the risk in many financials and utilities, some businesses in the traditionally defensive healthcare, pharmaceutical, consumer, and cable and media sectors are at risk of a downgrade after stretching their finances for acquisitions.

Are these markets problematic? We believe so, because of the answer to the first question: What will the end of this cycle look like? We address this in our latest Fixed Income Quarterly.

V-Shaped or U-Shaped?

Since the early 1990s, we have experienced V-shaped turns in cycles: GDP growth moving from 4% to -3% and back again within six quarters. The recovery from the 2007 - 09 financial crisis was slower, but still followed this basic template.

The V shape depends upon a robust monetary and fiscal response to a slowdown. In this cycle, however, the Fed is unlikely to have its usual, 5%-plus starting point for rate cuts. Moreover, the post-crisis playbook will have lost some of its shock-and-awe impact. As U.S. policymakers have already enacted more than $1.5 trillion worth of fiscal stimulus this year, adding more in the next recession will be challenging and potentially less effective, too.

With these two policy levers compromised, we think the next turn is much more likely to be U-shaped than V-shaped-and a prolonged growth drought would be grindingly tough for those markets where we have identified excesses.

Excess

The real point, however, is that we can already identify that excess. In some cycles, it has paid to hang on to the "high-beta" assets to benefit from the full share of the remaining upside. This time around, the potential upside from these overheated markets appears vanishingly small.

In other words, no matter when you think the cycle will end, it is not too early for credit investors to consider building a bias to quality and tightening up issue-selection criteria. If you have a multi-sector fixed income portfolio, caution against giving in to the temptation of going all-in for the emerging markets rebound or a high-yield "melt-up," and remain in favor of being well-diversified across all markets and regions.

How long can this cycle go on? I'm not sure - but I'm pretty sure it's not forever.

In Case You Missed It

  • S&P Case-Shiller Home Prices Index: July home prices increased 0.3% month-over-month and increased 5.9% year-over-year (NSA); +0.1% month-over-month (SA)
  • U.S. Consumer Confidence: +3.7 to 138.4 in September
  • U.S. New Home Sales: +3.5% to SAAR of 629,000 units in August
  • Federal Open Market Committee Decision: The FOMC raised the Federal Funds rate a quarter percentage point, to a range of 2% to 2.25%
  • U.S. Durable Goods Orders: +4.5% in August (excluding transportation, durable goods orders increased 0.1%)
  • U.S. 2Q 2018 GDP (final): +4.2% annualized rate
  • U.S. Personal Income and Outlays: Personal spending increased 0.3%, income increased 0.3%, and the savings rate remained at 6.6% in August

What to Watch For

  • Monday, 10/1:
    • ISM Manufacturing Index
    • Eurozone Purchasing Manager Index
  • Wednesday, 10/3:
    • ISM Non-Manufacturing Index
  • Friday, 10/5:
    • U.S. Employment Report

- Andrew White, Investment Strategy Group

Statistics on the Current State of the Market - as of September 28, 2018

Market Index WTD MTD YTD
Equity
S&P 500 Index -0.5% 0.6% 10.6%
Russell 1000 Index -0.5% 0.4% 10.5%
Russell 1000 Growth Index 0.7% 0.6% 17.1%
Russell 1000 Value Index -1.7% 0.2% 3.9%
Russell 2000 Index -0.9% -2.4% 11.5%
MSCI World Index -0.6% 0.6% 5.9%
MSCI EAFE Index -0.8% 0.9% -1.0%
MSCI Emerging Markets Index -0.2% -0.5% -7.4%
STOXX Europe 600 -1.5% 0.2% -2.4%
FTSE 100 Index 0.3% 1.2% 1.0%
TOPIX 1.5% 5.5% 2.0%
CSI 300 Index 0.8% 3.2% -12.8%
Fixed Income & Currency
Citigroup 2-Year Treasury Index 0.1% -0.1% 0.2%
Citigroup 10-Year Treasury Index 0.2% -1.5% -3.7%
Bloomberg Barclays Municipal Bond Index 0.2% -0.6% -0.4%
Bloomberg Barclays US Aggregate Bond Index 0.2% -0.6% -1.6%
Bloomberg Barclays Global Aggregate Index -0.5% -0.9% -2.4%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.2% 0.6% 3.9%
ICE BofA Merrill Lynch U.S. High Yield Index 0.1% 0.5% 2.5%
ICE BofA Merrill Lynch Global High Yield Index -0.1% 0.8% 0.5%
JP Morgan EMBI Global Diversified Index 0.7% 1.5% -3.0%
JP Morgan GBI-EM Global Diversified Index 1.0% 2.6% -8.1%
U.S. Dollar per British Pounds -0.4% 0.3% -3.6%
U.S. Dollar per Euro -1.2% -0.2% -3.3%
U.S. Dollar per Japanese Yen -0.9% -2.4% -0.8%
Real & Alternative Assets
Alerian MLP Index -1.3% -1.6% 5.9%
FTSE EPRA/NAREIT North America Index -1.1% -2.6% 2.4%
FTSE EPRA/NAREIT Global Index -1.5% -2.4% -0.8%
Bloomberg Commodity Index 1.0% 1.9% -2.0%
Gold (NYM $/ozt) Continuous Future -0.4% -0.9% -8.6%
Crude Oil (NYM $/bbl) Continuous Future 3.5% 4.9% 21.2%

Source: FactSet, Neuberger Berman.

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