2018 Q4 Legacy Group Commentary

Happy New Year.    Last year while writing the year-end commentary, we were contemplating the Zen-like calm that had taken over the markets.  Nothing could scare investors: rising interest rates…no biggie; potential trade wars…nothing to see here; geo-political conflict with North Korea…why worry?   But we all knew the calm would not last.  In that commentary we wrote: 

We don’t know what the year (2018) will bring.  Our guess is that there will be more volatility in the markets this year.  It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year.  However, just because it is more volatile does not mean it will be worse or better.  But, predictions aside, the most important thing to take from all of this is not to buy into the calm.  It will not last. 

The calm didn’t last.  2018 ended up being a volatile year with almost every major asset class ending the year at losses.  That quote is not meant as a victory lap.  There was nothing prophetical about our prediction.  It was just a recognition of investor behavior.  When markets are serenely calm, we can be certain that things will eventually turn volatile.  People will ignore bad news until suddenly they don’t.  We saw that transition in 2018.  What didn’t scare investors before became unsettling:  rising interest rates, trade wars, slowdown in corporate profit increases, and a potential recession on the horizon.  

What will markets do in 2019?  Every year we ask this question, and every year we give the same answer: we don’t know.  If you’ve been reading this commentary for a while, you know we are not big on market predictions.  “Expert forecasting” is rarely accurate (need I make the accuracy comparison to that of dart-throwing chimpanzees again?).  Last year, 85% of Wall Street banks surveyed by Fortune predicted the S&P 500 would post positive returns in 2018.   Well, that didn’t work out.  Even the banks surveyed who did predict negative returns were still over 200 points off with their projected ending points.  We don’t know why people think they can accurately predict where the markets are going to be at year end.  They crunch the numbers and somehow come up with a target, but they’re almost always wrong.  They ignore the reality that market movements from year to year have very little to do with numbers and almost all to do with investor sentiment. 

While we think predicting asset class returns for a given year is often a fruitless activity, we are confident that one thing will likely happen in 2019: the  economy will continue to slow.  Financial conditions are weakening.  Liquidity has been tight at times during the last few months.  The possibility of a recession is increasing, and indicators point to it starting sometime in 2020.  In the face of the changing conditions, the Federal Reserve is likely to slow their interest rate increases.  If history is any indicator, the markets will cheer the slowing of rate increases, but the applause won’t last long as economic activity continues to slow.  Financial markets will likely continue to exhibit volatility, but this will hopefully produce some opportunities to buy assets at cheaper prices.  Our conclusion is to remain wary of overly rosy predictions and to remain vigilant in allocating capital.  

Good Ol’ Fashioned Debt Binge

As we near the turn of the economic and credit cycles one area we are closely watching – and have been for some time – is corporate debt.  Corporations have two different methods to access financing: sell equity in the business or borrow money.  There is a cost to each method, and any time a corporation goes to financial markets for money, it assesses which market is the better option.  Over the last decade, tax law, the regulatory environment and extremely low interest rates made it very attractive for companies to finance activity through debt.  Corporations responded by going on a debt binge: total corporate debt in the US has gone from about $4.9 trillion in 2007 to over $9 trillion today.  That’s almost a doubling of corporate debt in the last decade. 

Investment Grade:
AAA
AA
A
*BBB*
Speculative Grade (Junk):
BB
B
CCC
CC
C
D

As more debt has been taken on, the overall financial condition of US corporations appears to have deteriorated. To the right is Standard & Poor’s credit rating system.  In their infinite wisdom, Standard & Poor’s and their contemporaries—Moody’s and Fitch—grant long term debt (bonds) issued by companies a rating.  This rating is meant to provide an indication of how likely it is for a company to make the scheduled interest payments and eventually re-pay its debt.  The better the rating, the more likely the lender is to get their interest and their money back. Think of the rating scale as an expanded school grading system: AAA is the best, awarded to bonds believed to be the most financially secure; head of the class.  As the chart descends, the quality of the debt decreases; i.e., the likelihood of the interest being paid and the lender getting their money returned goes down; the school drop-out, so to speak. I want to draw your attention to the BBB category.  BBB is the lowest “investment grade” category, just a step above what is “speculative grade,” which is also more affectionately referred to as “junk debt.”  Standard & Poor’s defines BBB as follows: An obligation rated ‘BBB’ exhibits adequate protection parameters.  However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.  

Why go to lengths to point this out?  Well, because there are a few of these BBB bonds floating around in the financial system.  And by a few, I mean a lot.  And by a lot I mean 50% of all outstanding investment grade bonds…somewhere around $3 trillion.  This is very different than it has been the past.  In 1990, BBB only made up about 25% of the market of investment grade bonds.  Going back to 1980, the median bond rating was A (that’s great!), and now the median is BBB- (not so great).  On average, corporate debt is as poorly rated as it has ever been, but that’s not where the problems end.  When you dig a little deeper, things deteriorate even further: companies rated BBB have almost twice the leverage (what they owe versus what they own) than they did in 2000 (1.7x vs. 2.9x). 

Based on these ratings, overall indebtedness, and leverage multiples it is clear there has been deterioration in the financial condition of the debt market to where almost half of all investment grade corporate debt is with companies who under adverse economic conditions or changing circumstances are more likely to have a weakened capacity to pay their debt.  The terms “adverse economic conditions” and ” changing circumstances” are vague and open to various interpretations. Here are a couple scenarios that may fit those terms: recession and rising interest rates. That interpretation yields the following reality: half of all investment grade corporate debt in the U.S. is likely to have a weakened ability to pay their creditors during a Recession or while Interest Rates are Rising.

Look lower down in credit quality, down in the junk bond portion of the markets, conditions have also grown riskier.   With low interest rates the past ten years, investors sought higher yields.  On Wall Street, there is no such thing as unmet demand.  Collateralized Loan Obligations (CLOs), Speculative Grade loans that are broken apart and then re-bundled with other loans, were sold at a record pace.  These types of loans were typically financed by banks, and the terms of the loan contained covenants – legal parameters that are meant to protect the lender.  Over the last few years, they are increasingly being issued “covenant-lite,” meaning without many of the normal lender protections.  To make the situation more precarious, more of these loans are being financed by non-bank entities who are not as closely regulated as banks.  When lending occurs outside of the banking industry, underwriting standards tend to suffer.  Simply put, junk debt is becoming junkier.  

Given these circumstances, we can see a scenario playing out where a lot of companies struggle under their debt load during a recession.  The cost to finance with debt has been rising over the last couple of years, but it has been outpaced by the high tide of earnings growth in a positive economic environment.  When earnings turn negative during a recession, the tide will wash out, and we will see who is swimming without a bathing suit.  Default ratios will increase among Speculative Grade bonds (they always do during recessions, but we wouldn’t be surprised if defaults rise more than normal), and a lot of these BBB bonds may drop from Investment Grade to Speculative Grade.  If those things happen, there will be a lot volatility and repricing in the debt markets.

As we look ahead to these risks, we will work to structure the debt portion of our portfolio to withstand these shocks and be ready to take advantage of any repricing opportunities.  We will continue to look for opportunities to invest capital at an acceptable level of risk.

Blake

Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

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