The Next Recession Begins on This Date
Editor's note: When it comes to individual companies, Wall Street often gets it wrong...
But the thing is, these problems aren't limited to the stock market.
Today's Masters Series essay first appeared last week in Professor Joel Litman's free Altimetry Daily Authority e-letter. In it, he explains how his "Uniform Accounting" metrics help to paint a more positive picture of the economy than you might believe...
The Next Recession Begins on This Date
This year, we headlined our January report for our institutional investors: "A RECESSION IS COMING... in 18 months to two years if trends do not change before then."
Trends have changed significantly in the past nine months.
Many market strategists, financial journalists, and regular investors are calling for a recession by the end of 2019 or sometime in 2020.
A select few even suggested the recession has already started.
Recently, in Altimetry Daily Authority, we wrote about the real trigger for recessions. We mentioned that there's no chance for a recession without a credit crunch caused by borrowers who are stuck with debt they can't refinance or retire.
We said to keep your eyes on 2021, when U.S. companies' obligations begin to exceed their cash flows.
But now, we have good news. We're moving our expected timeline for the next recession. We now believe there is even more life left in the current economic cycle.
While the U.S. has a big debt headwall coming in 2021, that can change when American corporations refinance their debt.
That wasn't happening last year or earlier this year... but it's exactly what we've been seeing recently. And it has been speeding up in the past few weeks.
There's a simple reason we're seeing a renewed interest in refinancing...
After rising massively in 2018, the costs for corporations to borrow have fallen.
We look at the credit default swap ("CDS") as a good proxy for how much it costs corporations to borrow. A CDS is a contract that acts like insurance for bonds. If a company can't pay its debts, a CDS ensures that the owner of the debt gets paid.
Much like health and property insurance, the higher the risk, the more expensive it is to insure. As such, in times of elevated credit risk, a CDS skyrockets in price.
Leading up to the Great Recession, the value of the CDS market ballooned to more than $62 trillion. Much like trying to purchase insurance midway through a car collision, it became impossible to buy a reasonably priced CDS...
The "price" of a CDS roughly matches the cost of a company to borrow, above the cost for the U.S. government to borrow – the risk-free rate ("RFR"). If we add together the risk-free rate and a company's CDS, we can understand how much the all-in cost is for a company to borrow money. And if we add up that number for all the companies that have CDSs, we can understand how much it costs in aggregate for corporations to borrow.
The chart below highlights CDS prices plus the RFR over the past decade. CDSs are broken into three buckets: investment grade ("IG"), crossover ("XO"), and high yield ("HY").
IG companies are the largest, safest, and most stable public companies, while HY companies are the smallest and riskiest. So it makes sense that HY CDSs are always more expensive than IG ones, and XO CDSs are always in the middle.
As you can see, the cost to borrow for all types of credit is significantly lower than it was in 2010, as we were coming out of the Great Recession.
Companies used those lower costs to consistently refinance their debt maturities. It made sense. When companies "roll out" their debt this way, they get to delay repaying it and see interest expenses decline or, at worst, stay flat.
Then in 2018, something changed. The refinancing market dried up. Companies weren't as active refinancing their debts. The cost for them to do so had risen significantly...
First, the Federal Reserve was actively hiking interest rates, with four rate increases in 2018.
And the underlying CDSs for corporate borrowers were rising, too, as perceptions grew that the bull market was running out of steam. The cost to borrow for IG companies rose from around 2% to 3.5% in 2018 through early 2019. The cost to borrow for HY businesses jumped from 3.5% to 5.5%.
Companies saw these interest-rate increases and paused their refinancing plans. That's how the debt-maturity headwall in 2021 got so big earlier this year.
But in recent months, we've seen a big inflection... which caused the refinancing market to return. It's why we think debt-maturity headwalls that had been looking material for 2021 are likely to be pushed out to 2022 and beyond.
Without those debt-maturity headwalls in 2021, there's no risk of a recession.
The rise in the cost to borrow in 2018 has completely reversed itself. Thanks to the Fed cutting rates and CDS levels moderating, the cost to borrow is roughly in line with what it was from 2014 through 2017, when the refinancing market was strong.
And that's not the end of the story...
Even corporations' reported costs to borrow overstates how risky corporate debt is. This is particularly true for debt with the largest yields.
Market CDS metrics are driven by investor demand, which is driven by how credit looks based on as-reported accounting figures.
The big credit-rating agencies – Moody's, Standard & Poor's, and Fitch – all use traditional accounting metrics when analyzing a company's credit risk. So do Wall Street analysts.
Because of this, their conclusions on credit risk lag reality.
Once we apply our "Uniform Accounting" metrics, we can calculate what credit risk really is for a company. We call this metric "intrinsic CDS," or iCDS. The chart below highlights the iCDSs broken into the same three buckets: IG, XO, and HY, plus the RFR. The real credit risk companies are facing is even lower than CDSs show you...
Our iCDS takes into account the real risk factors impacting each bucket of companies to understand what their real costs to borrow should be, based on that risk.
For the less volatile companies (IG and XO), intrinsic cost to borrow looks more or less the same as the current market costs for these companies to borrow. The market is correctly pricing their low and declining credit risk.
However, looking at the riskiest group of companies (HY), we can see something very powerful...
The market is overstating credit risk for HY companies.
While the market cost to borrow for an average HY company is around 4% right now, the intrinsic cost to borrow is around 3%. In the bond world, a percentage-point difference like that between market values and where a bond should trade is massive.
HY bonds are where most credit crises start. These are the companies closest to the cusp of bankruptcy and corporate restructuring at any given moment. Because of that, they are a particularly important canary in the coal mine for the economy as a whole.
If HY bonds are flashing an "all clear" signal – which they are today – that is a huge positive by itself... But when we're seeing signals that credit risk is even lower than the market realizes, that lowers the risk of a credit crunch and recession even more.
And that's before we even get into what it means as an opportunity for investors to buy individual high-yield credits, because they're being overcompensated for the risk they are taking when they buy those bonds. This is also something we've seen Porter and his research team highlight with their bond work in Stansberry's Credit Opportunities.
We already know that the risk of a recession is much lower than many on Wall Street are claiming, just by understanding how important the refinancing market is to economic growth.
But by using Uniform Accounting, we can see even more... Not only is the risk of a recession overstated, the actual risk of HY corporates – the highest-risk businesses – is even lower than the market realizes. As the market adjusts to this reality, it will give even more tailwinds to the refinancing cycle, extending out the risk of a recession to 2022 – if not even further.
Regards,
Joel Litman
Editor's note: While Joel doesn't believe we're close to a recession today, he thinks the market could move sideways over the next few months. But not every stock will struggle... In his brand-new High Alpha service, Joel and his team will use his innovative approach to spot the stocks that could double your money or more. And until tomorrow, you can become a charter member at a 50% discount to what others will pay in the future. Learn more here.