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Corporate Credit

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The blow-out in corporate bond pricing over the past two weeks has raised the question “are we seeing the bursting of a credit bubble?” We do not believe this is the case, but rather that we are seeing a fear driven flight to cash by investors as they digest the rapidly developing coronavirus situation and the knock-on effects on the economy. This is compounded by the inability of capital constrained Wall Street intermediaries to take large amounts of corporate inventory on balance sheet which has further widened bid/ask spreads.

The recent moves by the Fed should help, including reinstating the CP backstop facility and providing support for investment grade corporate bonds in the primary and secondary markets. The new issue market is open for investment grade credits viewed as defensive (i.e., telecom, utilities, food/beverage). Moreover, banks are being encouraged by the Fed to support consumers and business which are facing financial hardship due to COVID-19. We are seeing waves of headlines from banks of all sizes canceling their share repurchase programs and providing more support for borrowers. Private lenders are also working with customers to enhance liquidity, although transparency in that market is much more limited. 

Corporate credit risk needed to reprice in the current tumultuous environment. Companies, even in defensive sectors, like telecommunications, have withdrawn guidance given the unknowns related to the virus and the changes they have to make to their business to accommodate people during this time. Equities have repriced given the uncertainty in both earnings and the cost of capital. This spread widening reflects the increased volatility and illiquidity as well as default risk as the probability of downgrades increases. For BBB-rated corporate issuers, it is more meaningful which is why the spread difference between A and BBB credits continues to widen substantially. We are starting to see the credit ratings of companies directly impacted by the pandemic downgraded or placed on negative outlook by the rating agencies (e.g., DIS). Rating agency actions are difficult to predict in these environments as they have their own internal politics and risk policies.

This environment is a reason why companies maintain liquidity facilities and manage their debt maturity schedule. At this point, we look to prior recessionary periods to guide what might happen next. We had expected spreads to widen to 200+bps if a recession became a “base case,” and now the question is related to the timing and extent of the recovery to determine the peak in spreads. We estimate that approximately 25% of the investment grade corporate market or $1.6 trillion is reflecting the increased risk of falling to high yield with about 10% trading like high yield credits today. According to Moody’s about 12-13% of BBBs were downgraded to high yield in the mid-1980 and 2002 recessions. Therefore, while spreads could continue to widen, the market is already reflecting elevated risk of downgrades to high yield. We continue to expect downgrades will occur, but the order of magnitude to approximate $500 billion.

We expect spreads and liquidity to stabilize when there is a reduction in virus related uncertainty and it is clear that the Fed programs and fiscal initiatives are working to cushion the economy. Until then, we would expect volatility to remain elevated.

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From the floor of the 2020 Chicago Auto Show, AAM’s Senior Auto Sector Analyst, Afrim Ponik, and Insurance Sector Analyst, Garrett Dungee, discuss how electric vehicles, the economy, and other new technologies will impact auto sales and insurance.

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National Lampoon’s holiday sales summary

The holiday season continues to be a critical time of the year for retailers as some can earn up to 40% of their annual revenues during this period. Based on adjusted figures from the U.S. Census Bureau, retail sales (excluding auto and gas) for holiday 2018 were up 2.3%. This was the lowest growth rate since the 2008/2009 recession. In 2008, holiday sales were down 4.1% while 2009 improved to positive 0.1%.

The holiday disappointment in 2018 was caused by the government shutdown and significant stock market weakness related to volatility surrounding trade/tariff headlines. Our prediction of around 4% for 2019 is significantly better. The following report explores some of the key components of our analysis.

The consumer is stronger than the abominable snowman

We believe the most important driver of retail sales directly ties to consumer confidence. The table in Exhibit 1 summarizes our analysis of nine factors that contribute to that level of confidence measured year over year.

Exhibit 1

Source: Bloomberg, AAM

In 2018 statistics were good, and this year’s look slightly better. Based on the year-over-year analysis, it appears that several of these factors are close to peak levels. Even though we have not seen substantial improvement versus last year, we still consider the numbers to reflect a very healthy consumer. This part of the analysis should help support a strong holiday spending season.

Professor Hinkle is back in school – but is he on the nice list?

A review of data from the last twenty years (see Exhibit 2) reveals a significant correlation (77%) between “Back to School” retail sales (as measured in August and September) and holiday sales (as measured in November and December.) To model the trend, we use the U.S. Census Bureau’s adjusted monthly retail trade data which includes a variety of retail businesses (excluding motor vehicle and parts dealers and gasoline stations; sales in those segments have been more heavily impacted by factors outside the control of consumers).

Exhibit 2

Source: U.S. Census Bureau

Our regression model predicts adjusted holiday sales of 4.3% when using the 4.6% actual for “Back to School” sales in 2019. This is above the 20 year average of 3.7%. Comparatively, 2018 “Back to School” sales of 4.1% led to actual holiday sales of 2.3%. Clearly the model did not accurately predict holiday sales last year. However, it should be noted that most of the weakness last year came in December when the markets experienced heightened volatility related to the talk of trade wars, the government shutdown, and a severe equity market selloff.

Santa needs more elves for his workshop

Overall, holiday related hiring is projected to be mixed this year. In many cases a lower rate of hiring in brick and mortar is offset by a greater need for employees to support e-commerce sales. It’s difficult to draw major conclusions from these numbers given the struggle to hire part time workers due to current low unemployment and efforts to pay existing employees a higher wage. Some retailers, including Walmart, will give current employees the opportunity to work holidays instead of hiring seasonal workers.

According to the National Retail Federation (NRF), temporary hiring will range between 530,000-590,000 which is comparable to last year’s 554,000. As shown in Exhibit 3, Kohl’s is the only retailer who plans to add more seasonal jobs this holiday season.

Exhibit 3

Source: Company press releases, Morgan Stanley Research

Deck the halls with tariffs for all

The second wave of tariffs is expected to begin on December 15th. This is in addition to new tariffs that began on September 1st , which included traditional holiday items such as TVs and apparel. We would expect the direct impact on consumer spending to be limited as we believe price increases during the holiday will be very limited. Nonetheless, 79% of consumers surveyed for NRF in September were concerned that tariffs will cause prices to rise, potentially affecting their approach to shopping. Shoppers expect a good deal and know when and where to make the best value purchase. For the most part, this is expected to be a “company” problem not a “consumer” problem. That could change in 2020 if tariffs remain in place and/or become more onerous.

There could be a secondary impact on spending from ongoing trade talks and tariffs. Large retailers have been diversifying their supply chains. It’s possible we will see disruption on that front which could cause less product to make it to the shelves, diminishing demand. In addition, negative headlines related to trade could create market volatility, leading to uncertainty and lower holiday spending.

Kris Kringle or Cyber Santa?

Online sales continue to grow at a double digit rate, which help retailers maintain overall business as foot traffic to brick and mortar locations continues to decline. Another positive is that weather has become less of a factor for retail results as online sales become easier and more popular across demographics. According to the U.S. Census Bureau, e-commerce now accounts for 12.5% of total retail sales year-to-date. We believe that figure is above 20% if one excludes segments that are not currently at significant risk of an internet presence such as auto sales, restaurant/bar sales, and gas station sales. Through October growth for the online category was 12.7%. That’s almost four times the 3.2% growth of total retail sales year-to-date.

Exhibit 4 illustrates the power of just one of the many trends developing in e-commerce. The graph below shows the opportunity to grow online sales in the discounted space led by Walmart and Target. Both of these companies have tremendous resources and initiative to compete in the space. Their growth is ramping up at the expense of Amazon and eBay. The ability to shop online and pick up your item at your local Target or Walmart has become extremely popular. With several thousand stores spread across the U.S. these retailers have a significant advantage.

Exhibit 4

Source: B of A, Merrill Lynch

Several sources have reported successful Thanksgiving and Black Friday shopping results. According to Adobe Analytics, online sales (desktop & mobile) of $11.6 billion were up 17% over last year. That compares to 25% growth for 2018. Sales completed on smartphones continue to be the largest driver of e-commerce with smartphone sales accounting for 41% of online sales versus 31% last year. According to ShopperTrak, visits to stores over the two day period fell 3% with a 6% drop on Black Friday. Black Friday results were slightly weaker given heavy promotion in the beginning of Thanksgiving week and an earlier start to holiday shopping given lower than usual available shopping days until Christmas.

Dasher, Dancer, and Prancer agree that Santa will be busy

We have included a summary of three trade groups that publish their views on upcoming holiday sales. While each of them use a different data set to support their expectations, it is still important to note the growth year-over-year. In addition, we thought it would be interesting to look at how accurate each group has been over the past four years. Based on this data, we would not favor any one of these trade group’s prediction over the other. Also, it’s clear they all were too optimistic last year as was the majority of the Wall Street analyst community.

Exhibit 5

Source: AAM

According to a survey released by the National Retail Federation (NRF), shoppers will spend an average of $1,048 in 2019 for a total of approximately $728 billion. Shoppers plan to spend most of their time online and in department stores. For the 13th year in a row, the most popular present is expected to be gift cards. The most important factor when shopping at a particular retailer remains sales and discounts.

Walking in a not-so-wintery wonderland

Weather and the shifting calendar are always important factors for holiday spending. According to Weather Trends International (WTI), December is expected to be slightly cooler with temps averaging 37.4F. Average precipitation for December is expected to be down 26%. The ideal weather for traveling holiday shoppers is cold and dry. Retailers want shoppers to buy winter products but not be turned away by heavy snow.

Exhibit 6

Source: Weather Trends International

Exhibit 7

Source: Weather Trends International

A key statistic tied to the strength of holiday retail sales is the number of days between Thanksgiving and Christmas. The maximum number of days possible is 32 and the minimum is 26. Obviously, for retailers the more shopping days between Thanksgiving and Christmas the better. This year, the total shopping days is 26, the minimum, versus the maximum 32 from last year. In addition, there are eight total weekend days to shop which is the minimum, versus the 10 weekend days we had last year.

Tie it up with a bow

We are optimistic about 2019 holiday spending. Consumer confidence is high and consumers are ready to spend this holiday season. The key predictor of back-to-school sales was better than last year, and the retail sector continues to expand with the ease and efficiency of online shopping. While tariffs and trade talk continues to create volatility in the financial markets, consumers seem to dismiss the potential downside. Of course, this is easier to do with the stock market up 246% year-to-date and with limited price increases expected during the holiday season.

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Market summary

The Investment Grade (IG) Corporate bond market (per Bloomberg Barclays Index) struggled in the third quarter, as spreads widened. Excess returns over Treasuries were slightly negative at -0.2%, but with the Treasury yield rally, total return was 3.1%. The IG market outperformed the S&P Index, which returned 0.9% and High Yield market (per Bloomberg Barclays Index) at 1.1%. 

The risk asset rally in the first half of the year started to stall in the third quarter, as investors became more concerned with the economy. As the probability for recession has increased, so have risk premiums for weaker credits. This was exemplified in the third quarter by weakness in the IPO market (Renaissance IPO Index -10.1%), small caps (Russell 2000 Index -2.6%), and CCCs (Bloomberg Barclays CCC -1.8 %). The leveraged loan market has struggled of late as well. While credit remains available as reflected by the strong demand in September for new issue IG credit and weekly data from banks, the weakness in these higher risk segments of the markets coupled with projected GDP growth are not constructive for spreads in the near term. 

IG corporate credit spreads have been supported by very strong technicals, and we expect this to continue in the near term. Demand for USD bonds as measured by ETF and foreign buying has increased this year, and net debt issuance (i.e., supply) is at a post-crisis low.  M&A activity has slowed despite very compelling financing costs for companies, which reflects uncertainty in the C-Suite regarding global growth and domestic policies, a situation that is unlikely to abate as we enter an election year.   This makes it more likely that issuance remains low in 2020 and debt leverage for companies stable/improving, in addition to keeping fixed investment (capital spending) depressed.

Market outlook

For the fourth quarter of 2019, we expect central banks to remain dovish, but the trajectory of economic growth remains concerning. The risks to the downside for U.S. GDP growth have increased with: (1) disappointing ISM reports and leading indicators that point to further downside (2) softening business confidence which suggests investment growth could slow further, and  (3) slowing job creation and hours worked with top line pressures increasing cost cutting rhetoric. However, positive data points include the stabilization in China manufacturing PMI and a rebound in the U.S. housing market. A more constructive tone towards trade is helpful, but we remain skeptical that this issue will be resolved before the election. 

In summary, due to very strong technicals, current spreads reflect stronger fundamentals than those that exist today or that we anticipate in the near term. The heightened level of uncertainty and the expansion and resulting debt created post financial crisis alongside challenging demographics diminish growth potential. Low rates have worked to fuel investment and capacity, and as expectations are revised and lower growth rates are accepted, we would expect to see that start to rebalance and impact demand. This means we would expect risk to reprice in this next phase of the cycle and defaults to creep higher. While we would expect spreads to widen before fundamentals improve, as the cycle plays out, we recognize timing of this is difficult. 

We entered October with a neutral opinion on the IG Corporate bond sector given our view that technicals would remain supportive and we would avoid a recession in the near term. As spreads have rallied this month in reaction to the potential trade agreement with China, we are selling BBB rated credits that have outperformed. We are recommending a defensively positioned Corporate portfolio given the increased economic risks and lack of appropriate risk premiums (industry, credit quality, and maturity). We are in a position to add risk when spreads become more attractive and continue to take advantage of attractively priced opportunities.

Figure 1

Source: Bloomberg Barclays Index, AAM

Figure 2

Source: Bloomberg Barclays Index, AAM

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We all know Warren Buffett as perhaps the most astute investor of our time. His success within the financial markets is legendary. But do you know what the Oracle of Omaha chose if he were stranded on a desert island and could pick only a single indicator to help him navigate through the financial markets? Rail traffic. This paper will examine the logic behind this unexpected and atypical perspective.

Why are railroads important?

The U.S. freight railroad system comprises about 140,000 miles of track and consists of hundreds of railroads. The largest are called “Class I” and include CSX, Norfolk Southern, and Burlington Northern Santa Fe (BNSF). Most of what you touch, eat, and interact with on a daily basis most likely, at one point or another, traveled on one of these railroads.

Exhibit 1

Source: Association of American Railroads as of June 2019

Railroads ship both raw materials used in the production of finished products as well as the finished products themselves. And rail supports a wide variety of industries including automotive, agriculture, energy, and construction. Shipping goods via rail is an attractive alternative for several reasons including economic efficiencies (rail can move one ton of freight more than 470 miles on one gallon of fuel), reliability, and access to international markets. Railroads account for about one-third of U.S. exports by volume. These industry characteristics make for an interesting way to gauge the pulse of the economy. 

The data

Rail traffic data is released weekly by the Association of American Railroads (AAR) and is broken down by number of railcars per each category including intermodal. Intermodal is defined as the long-haul movement of shipping containers and trailers by rail combined with a truck or ship at either end of the journey. The following is a snapshot of the AAR report:

Exhibit 2

Source: Association of American Railroads

A breakdown of each category offers additional background on how each is viewed as an economic indicator: 

Chemicals (6%) – Consists mostly of industrial chemicals, plastics and synthetic fibers, and fertilizers. This category includes thousands of products and serves as a good proxy for general growth especially in manufacturing. 

Coal (15%) – About 8% of U.S. coal is exported, double from 2017. Low natural gas prices and advanced renewables are replacing coal as a source of generation for electricity, which means it is less reliable as an economic indicator

Farm Products (3%) – Includes feed for livestock and a very wide variety of food for human consumption. Refrigerated rail cars have come a long way in moving perishable products to rail and away from trucks.

Forest Products (2%) – Consists of lumber and paper products. Transport of lumber is highly correlated to housing starts, a key economic indicator.

Grain (4%) – The United States is the world’s largest grain producer. The market is somewhat unpredictable given difficulty in forecasting crop size due in part to weather and soil conditions.

Metallic Ores (4%) – Includes iron ore, steel scrap, and coke. Impacted by the health of the steel industry and manufacturing (i.e., appliances).

Motor Vehicles (3%) – Rails are involved in several stages of the auto production process including materials for steel, parts, and finished vehicles. A single train can move 750 vehicles at once.

Nonmetallic Minerals (7%) – Includes materials for a wide variety of construction projects including crushed stone, sand, and gravel. Analysts estimate that about 80% of crushed stone is used as a construction material mostly for road construction.

Petroleum (2%) – Crude oil volume for rail is impacted by pipeline capacity and oil prices. Domestic production in shale oil, especially in North Dakota and Texas has created opportunities for the rail industry.

Intermodal (51%) – Rail has invested a tremendous amount of resources into this business. Customers can move twice the freight for the same price paid 30 years ago. Intermodal has helped address the difficulty of hiring long haul truckers. In addition, this segment has a large international component. 

Is this a good indicator?

We recognize for an indicator to be reliable, it needs to be statistically credible. We analyzed the different subsets of the rail carloading data to measure their significance as a predictor of economic data points, including GDP growth. We found that the best combination was total traffic, excluding grain and coal. We removed grain and coal because volumes in those categories often change based on factors outside the scope of economic growth. For example, coal volumes change based on the price of natural gas and grain volumes can be severely impacted by unexpected weather patterns. 

Using data going back to 1997, we find a correlation of 66%; R squared of 43% and a statistically significant relationship as noted by the t stat. Given this data we characterize the relationship as having a relatively strong correlation. 

The exhibit below illustrates the relationship of the two variables, which is helpful since GDP data is released with more of a time lag than the railcar loading data.

Exhibit 3: Rail carloading growth vs. GDP growth (Y/Y)

Source: Bloomberg, AAM, Association of American Railroads as of 6-30-2019

Future trends

At this point in the third quarter we have nine data points (Note: each quarter has a total of 13). So far, railcar loadings QTD are down 4.3% compared to last year. If the trend continues for the remainder of the quarter, the change year over year would look similar to 2Q19 which was down 4.5%. Based on our analysis, we would expect GDP to trend lower or stabilize around 2.0%. Currently, the estimate for Year over Year growth for 3Q19 GDP is +2.1%, and for 4Q19 GDP is +2.2%. Economists seem to agree!

Exhibit 4: Rail carloading growth vs. GDP growth (Y/Y)

Source: Bloomberg, AAM, Association of American Railroads as of 8/31/2019

Will we see the impact of the “trade war” in rail traffic?

The quick and easy answer to that question is, yes. The US/China trade dispute continues to evolve and freight railroads play a very important role in international trade. The Association of American Railroads estimates that at least 42% of the carloads and intermodal units railroads carry are directly associated with international trade. In addition, 35% of rail revenue is accounted for by international trade. Of that amount about 36% was from intermodal containers with the remainder from other carload traffic. 

On August 1st, the office of the US Trade Representative announced a new round of additional tariffs. The proposed “List 4” tariffs are more retail and consumer oriented. The effective date of September 1st for this third phase of tariffs gave companies little opportunity (one month) to stock up on Chinese goods before prices increased. Therefore we would not expect to see a “pull ahead” of ordered goods like we did at the end of 2018 when the timeline was not as compressed. That said, we expect car loadings to be impacted by negative sentiment, lower import/export volume, and permanent supply chain reorganization. The exhibit below shows the estimated cost of the tariffs per household as estimated by JP Morgan. We would expect the impact to the consumer to come through in the weekly rail traffic numbers and eventually impact GDP.

Exhibit 5: Estimated Cost of Tariffs on Households

Source: JP Morgan as of 8-23-2019

Summary

Rail traffic may not have been at the top of your list of indicators, but, given its statistical relevance, we believe it deserves some attention when forming a strategic opinion on the economy. It’s interesting to note that not so long after that comment from Warren Buffett, Berkshire Hathaway purchased Burlington Northern Santa Fe for about $44 billion (February of 2010). Talk about putting your money where your mouth is!

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Market summary and outlook

The Investment Grade (IG) Corporate bond market (per Bloomberg Barclays Index) continued its strong performance in the second quarter, delivering a 5% total return given the Treasury rally, with spreads tightening only 4 basis points (bps). The IG market outperformed the S&P Index, which returned 3% and High Yield (per Bloomberg Barclays Index) 2%.

Risk assets have rallied this year around  investor expectations for more accommodative central banks and benign outcomes related to trade agreements and geopolitical issues. Over the past couple weeks, more hawkish Fed commentary, increased risks of a hard Brexit and a prolonged trade war with China have caused spreads to widen and market volatility to increase. The Treasury curve continues to signal a recession is likely in the near term, although credit remains widely available.  That was reiterated in the Senior Loan Officer Survey released this week as well as by the bank CEOs in second quarter earnings calls. The availability of capital keeps the credit cycle alive. 

IG corporate credit spreads are tight on a historic basis, reflecting very strong demand for USD bonds, as yields dropped in the first half, especially overseas. The supply of USD corporate bonds has been less than expected, as lower growth and heightened uncertainty has resulted in less capital spending and reduced appetite for increased debt leverage. While companies continue to repurchase shares and pursue acquisitions, it has been largely with free cash flow and within boundaries set by the rating agencies. We expect that behavior to continue, although the risk of bad behavior (i.e., debt funded share repurchase and/or M&A activity) increases as debt yields fall. We note an increasing number of IG companies have dividend yields that materially exceed their cost of debt.

For the second half of 2019, we expect central banks to remain dovish and economic growth to remain positive in the U.S. That is supportive for IG credit. The risks to the downside are largely growth related, factors that would increase the probability of a recession in 2020. Credit risk premiums for low quality and/or cyclical credits would likely widen more significantly, and more liquid sectors would see spreads widen as investors move into safe haven securities.

With lackluster valuations today and the expectation for late cycle spread volatility to continue, we are taking advantage of opportunities to optimize portfolios. The duration of the Corporate IG market has extended; therefore, with low credit spreads and volatility expected to remain elevated, there is little room for error in total return portfolios and with Treasury yields and spreads this low, fewer compelling income opportunities for yield buyers. Security selection and the ability to execute on investment ideas are critical in this late cycle environment.

Performance summary – 2Q2019 reflected investor unease 

Volatility picked up in the second quarter with trade related concerns. Spreads tightened In June after the market was comforted by dovish messages from the ECB and the Fed along with a fairly benign G20 summit. Economic data also came in weaker than expected in the second quarter, which once again, was interpreted as good news to the market.

Exhibit 1: OAS Volatility Increased in 2Q2019

Source: Bloomberg Barclays, AAM as of 6/28/2019

In the second quarter, merger and acquisition activity picked up and a number of weaker IG credits reported disappointing results, causing idiosyncratic risk to rise vs. the basis rally in the first quarter. Energy, Technology and Utilities underperformed in the second quarter vs. more domestically focused sectors with more stable cash flows such as Communications and Consumer Non-cyclicals. The relative value of BBB rated corporate bonds was little changed in the second quarter, and we took advantage of spread widening especially in new issues and secondary offerings in credits we expect will improve fundamentally. 

Exhibit 2: Excess Returns 2Q2019 (%)

Source: Bloomberg Barclays as of 6/28/2019, AAM Data

Fundamentals become challenged in a low growth environment

Unlike the period in 2011-2013 when U.S. economic growth and interest rates were low, fueling a rebound in 2014-2015, the domestic economy is more mature and China appears less willing to stimulate its economy. Stimulus thus far has been very targeted since it has much to balance, chiefly its debt as well as its currency in the midst of trade negotiations. This week is an example of sensitivities around not only the actions taken but the uncertainties and unintended consequences regarding those actions. 

It is clear that companies exposed to Europe and China are facing greater revenue pressure and continued weakness is driving forward estimates lower. From a tariff and cost perspective, while mid-to-large U.S. companies have been able to navigate this headwind by moving production out of China and/or eliminating jobs in these soft economic regions, small companies have had more difficulties. Until the uncertainty related to trade falls, revenue and capital spending outlooks should remain pressured especially for small companies. We note loan demand from small companies has weakened since the second half of 2018 despite accommodative lending standards. Moreover, sectors like Materials and Technology have been more volatile given their exposure to China and Europe. From a credit perspective, after the 2016 downturn in commodity prices, Materials companies improved their balance sheets and are in the process of being upgraded by the rating agencies. Conversely, since 2016, BBB rated Technology companies have done less especially given the cash flow volatility in a recession, making them more vulnerable. 

While not as strong as last year, domestic oriented companies have largely reported good results in the second quarter, as the consumer continues to spend and service related firms remain relatively healthy. According to Bloomberg and AAM data, revenue growth for North American firms geared towards the consumer or commercial sectors is estimated to be 5-7% for 2019 and 2020, with EBITDA growth rates expected to be higher as margins are forecasted to expand. Industrial related firms are expected to grow a little less at 3-5%. The weakness for North American firms is reflected in capital spending, which is expected to grow modestly this year (except for industrial firms) but turn negative in 2020.

Take advantage of spread volatility

We are reminded that IG spreads have widened post the financial crisis for mainly one reason, increased recession risk (e.g., 2010-2012, 2015-2016, 2018). We believe the best case scenario for the IG market in the second half is for domestic growth to remain around 2%, allowing the Fed to remain dovish. That environment should allow spreads to remain range bound in the 100-150 bps range. We believe the downside risks are mainly (1) slower than expected growth or (2) an unexpected macro shock. We note our signals for economic concern remain “yellow” with the Treasury curve flashing “red” while lending conditions remain “green.” Importantly, management commentary about the economy and forecasts for the second half while softer have not been overly bearish. That has been helpful in predicting recessions in the past.

If rates were to surprise to the upside due to stronger growth prospects (including a resolution to the China trade conflict), which at this point appears unlikely in the second half, spreads should be supported by yield sensitive investors especially since yields overseas are very low. According to Bank of America, the US currently pays 89% of all global investment grade yield despite accounting for roughly half of the $55T global IG bond market. In addition to strong foreign investor demand this year, fund flows have been strong year-to-date with the prospect of low rates, only second over the last ten years to the very strong inflows in 2017. Mutual funds and foreign investors have been the primary drivers of demand for IG corporate credit over the years, absorbing the increased supply. 

Spreads have fallen below our expected range for this year even with the spread widening over the last week. We are not forecasting a recession in the near term; therefore, we continue to invest in corporate credit. However, valuation is lackluster so security selection remains important. We continue to advocate taking advantage of the volatility in spreads, adding credits we favor fundamentally on spread widening and reducing risk when spreads tighten, especially for credits that exhibit a higher level of spread volatility. As shown below, since the beginning of 2018, we have seen spreads widen 50-100 bps in periods of volatility.

Exhibit 3: Current Spreads at Mid/Low End of a Volatile Range

Source: AAM, Bloomberg Barclays Index (Current: 7/9/2019; Range 1/1/2018-7/9/2019)