The Big Idea
Dislocation and opportunity
Steven Abrahams | December 7, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The markets over the last eight weeks have both reflected change and caused it. Markets have reflected concern about the performance of corporate credit in a decelerating economy, and the resulting wider spreads across corporate and other markets have tightened financial conditions. Fair value has shifted. There’s emerging dislocation and opportunity.
Tactically underweight 10-year duration
With fair value around 3.00% and with a fair range of 2.75% to 3.25%, current 10-year yields of 2.85% look like a good point for starting an underweight. Lower equity values and wider credit spreads since September have tightened financial conditions, but the market arguably has overestimated the impact on growth and inflation. The Goldman Sachs index has tightened 75 bp since September, and the Chicago Fed’s adjusted index 13 bp (Exhibit 1). Both show financial conditions at some of their tighter levels of the last five years. The market has done some of the Fed’s work for it, and the fed fund futures market since September has taken 35 bp of hiking off the table next year. That sounds reasonable, and the Fed may signal as much in its December dots. But with labor force growth and productivity pointing to fair value in real rates of 1.25% or more and with inflation targeted at 2.00%, 10-year yields temporarily look a little low.
Exhibit 1: Financial conditions have done some of the Fed’s work
Allocate out of corporate into household credit
Much of the spread widening in corporate debt arguably reflects the expected impact of decelerating economic growth on the elevated leverage on corporate balance sheets. As the economy slows, corporations have less gross revenue for paying down debt, and that should demand a higher risk premium. The market has clearly demanded one. The economy looks likely to decelerate further in 2019, so pressure on corporate spreads should continue. The household balance sheet, by comparison, is much stronger. Real median household income and household net worth are at record highs, and household debt service as a percent of disposable income is at a record low. Consumer asset- and mortgage-backed securities should outperform corporate debt.
Emphasize security selection
The sizable moves since September and other developments have opened the door across asset classes for adding to potential gains and trimming potential losses. A few of the more notable:
* * *
The view in rates
The Fed’s dots offered a simple guide to the likely path of shorter rates for most of the year, but the tightening of financial conditions since September has started doing some of the Fed’s work. The market has repriced for fewer Fed hikes next year, and the Fed may validate that at the FOMC on December 19. Absent anything else, fair value along the curve should sit somewhere around 3.0%. Potential tariffs, however, have added risk that the economy could decelerate next year more than expected. For now, assume the market has priced in too much tariff risk and that longer rates will bounce higher from 2.85%.
The view in spreads
Credit spreads should continue widening until they have priced fully for decelerating growth next. Slower growth poses risk to the nearly $3 trillion in ‘BBB’ credit, especially the most highly leveraged names. Names that show organic growth or use free cash flow or asset sales to pay down debt should perform the best. Wider spreads in corporate credit should put pressure on other spread assets, although consumer debt should show less volatility. Agency MBS, which also will need to adjust to likely falling bank appetite, should widen, too.
The view in credit
Although corporate balance sheets have to deal with higher leverage, household balance sheets looks strong. The weakest pockets on the household balance sheet look like subprime auto credit and student loan debt.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of Amherst Pierpont’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, Amherst Pierpont may act as a market maker or principal dealer, and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://apsec.com/disclaimers.
Copyright ©2022 Amherst Pierpont Securities LLC and its affiliates (“Amherst Pierpont”). All rights reserved. Amherst Pierpont Securities LLC is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, Amherst Pierpont (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which Amherst Pierpont has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of Amherst Pierpont’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, Amherst Pierpont or any of its affiliates may act as a market maker or principal dealer, and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by Amherst Pierpont, (iv) should not be reproduced or disclosed to any other person, without Amherst Pierpont’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, Amherst Pierpont (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.