Submitted by Joseph Calhoun via Alhambra Investment Partners, [7]
Oil prices plunged, junk bonds hit a 2 ½ year low, stocks took a nearly 4% hit, a junk bond fund halted withdrawals, the country’s biggest pipeline operator cut its dividend by 75% and two of the biggest mining companies in the world suspended theirs completely. It was not a good week for financial markets. And the Fed meets to hike interest rates next week for the first time since the 2008 crisis. After hinting so hard for so long, it is hard to see how the Fed could not follow through on their threats but the markets and economy aren’t making it easy. I said at the beginning of the year the Fed would not hike in 2015. With one meeting to go, I’d say my odds are still about 50/50.
I’ve been warning about junk bond credit spreads for over a year now. We watch them closely because they have, in the past, been a great indicator for stocks. Spreads first started widening in the summer of 2014 and that led to a stock market correction in October of that year. Spreads narrowed for a while after the first of the year and then resumed their widening in June of this year. We lowered our allocation to stocks in early August [8] for exactly that reason. Now spreads have moved to their widest since the pre-Mario Draghi whatever it takes Euro crisis of 2011.
The trigger for last Friday’s big selloff in junk was the shutdown of a Third Avenue credit mutual fund. The fund had suffered big losses this year – over 25% – and was getting redemptions faster than a coupon for free Ben & Jerry’s. Rather than accept fire sale prices in a thin market, the firm decided to pay out what they could in cash and liquidate the rest over time. We see this kind of thing in hedge funds more often but seeing it in a retail open end mutual fund is a bit jarring. However, this was not just a run of the mill junk bond fund. Actually, it is – was – more of a distressed debt fund, not exactly the most liquid of assets in the best of times.
Still, the perception – and that’s all that matters – was that a junk bond fund had run into liquidity problems and shut down. It was not the first fund to experience problems. A Carlyle owned hedge fund called Claren Road halted withdrawals in October. Again, not all that unusual for a hedge fund and again not a pure junk bond fund so it didn’t have much impact at the time. What should concern investors is not the structure of the funds or the exact nature of their holdings but rather the large redemption requests. Investors are withdrawing from the riskiest parts of the bond market and that has implications for the real economy, not just a few junk bond fund investors.
Credit spreads are a sign of investors’ willingness to take risk. Widening spreads mean investors are avoiding risk, selling bonds with credit risk in favor of bonds with none – Treasuries. This risk avoidance, this fear, often leads to more risk avoidance, more fear and more selling. As someone put it last week, people are worried about people being worried.
The bullish argument until now has been that the widening of spreads was just about energy and nothing about which to worry. But as I said in January [9], a problem in one sector is unlikely to stay in that sector for long. Funds facing big redemptions don’t have the luxury of selling only energy bonds. When someone pushes the sell button for HYG, it isn’t just energy bonds that are getting sold. The selloff in junk bonds will have an impact on economic growth if it persists. Higher interest rates for junk borrowers reduces economic growth at the margin. The total impact on the economy is impossible to know in advance. How much of our recent tepid growth was a function of easy credit in the junk market? My perception is that it was a greater proportion in this cycle and junk bond issuance over the last 6 years would seem to support that contention. The size of the junk bond market has roughly doubled since 2007.
There are competing positives and negatives right now though. Lower oil prices – a higher dollar – are a positive for economic growth but not, as most presume, because it raises consumption. A higher dollar is positive because it shifts consumption and investment. Rather than channeling spending to oil companies so they can punch holes in the ground, capital flows to investments more likely to raise productivity and real economic growth. Unfortunately, that doesn’t happen overnight. People must believe, first of all, that the dollar will remain strong, that oil and other commodity prices won’t go right back up. We may be nearing that capitulation point as the oil market in particular had the whiff of panic about it last week.
Even after that, it takes time for new profit opportunities, new investments, to emerge. The interim may not be a recession. It could just be a growth cycle slowdown that never develops into a full recession. I think that depends, as I said above, on how much of recent growth was fueled by cheap credit to junk borrowers. With growth at only a tad over 2%, there isn’t a lot of room for error. We already have an “earnings recession” and a “manufacturing recession”. We already have an “oil patch recession” and a “mining industry recession”. I’m not sure how many more “recessions” the system can take before we can just remove all the qualifiers and quotation marks.
The economic data last week certainly didn’t offer much comfort. The JOLTS report, cited most often by bulls recently, showed a contraction in job openings and the July peak is fading in the rear view mirror. Inventories are still way too high relative to sales. Jobless claims aren’t particularly worrisome but they are at a 5 month high. The Quarterly Services survey was weak showing a sequential, quarter to quarter, decline in the annual growth rate. Retail sales were less than expected. Within that report was the news that auto sales were down for the second straight month.
I won’t be shocked if the Fed actually follows through and hikes rates this week. If they put off hiking every time the market has a little hissy fit, they’ll never get off zero. On the other hand, the stress in markets right now is real and growing. Raising interest rates doesn’t seem likely to improve those conditions. With a riot in the junk bond market, a complete lack of inflation and an already weakening economy, I won’t be shocked if they pass either.