The appetite for risk continues. Since March, equities, commodities and credit have all rallied significantly, posting double digit (un-annualised) returns.
Talk of a stabilisation of the housing market is rife, as is an inventory-restocking led rebound in demand. Confidence among UK consumers and manufacturers is reportedly rising.
Why buy bonds when things are going so well? Why not hold the most risky assets in an environment of plentiful liquidity, potential inflation and demand for risk? If the economy is set to grow again, and there is a risk of overheating due to the huge amounts of cash thrown into the financial system by the central banks, surely fixed income is not the best place to be.
Flawed argument
There are numerous flaws in this argument, outlined below, including: a) the premise is incorrect, and b) if it were correct, ‘automatic stabilisers’ would act to dampen any overheating. When these flaws are considered, the conclusion can only be that investment grade credit will remain a very good place to be for quite a long time to come.
To clarify why the premise of the argument is incorrect. We have avoided disaster, and investors should not expect to see queues in front of banks for the rest of their careers.
This is not the same as a runaway economy where the riskiest assets outperform and those on a fixed income despair of high inflation eroding their returns. Recent corporate results have exceeded the expectations of many equity analysts. There have been improvements in certain macroeconomic indicators.
However, if you look at the detail, corporate directors remain very cautious amid the weakest conditions many of them have ever experienced. Given the substantial information set available to company management and their general tendency to optimism, their cautious stance indicates that we are at the beginning of relatively long, slow return to normality.
This will be supportive of investment grade bonds. It means that corporate managers will behave in a credit-friendly manner and inflation will not materialise anytime soon. With bonds still cheap and the supply/demand dynamics highly supportive of continued tightening of credit spreads, this is an exceptionally positive time for bond investors.
Corporate caution
To understand the views of company management it is helpful to look at some recent statements and results. Jim Owens of Caterpillar: “There is still a great deal of economic uncertainty in the world, but we are seeing signs of stabilisation that we hope will set the foundation for an eventual recovery.”
This is an unusually heavily caveated statement from the chairman and CEO of the largest manufacturer of construction and mining equipment. These are not words without substance either. Caterpillar has cut the full time workforce by 15% since 1 January and has reduced inventories by 10%, added to its cash stockpile and cut capital expenditure to about 22% of 2008 levels.
These are not the actions of a company positioning for any kind of near term recovery. Interestingly, Caterpillar’s equity skyrocketed on the earnings results, but that is a story for another time.
Investment bank spin
Part of the near euphoria on certain days may be due to the way that the investment bank community interprets events and results. For example, when reporting on BMW’s recent results, one bank stated that ‘‘management sees the first signs of light at the end of the tunnel.’’
Management actually said that ‘‘Consumers are becoming less willing to spend, particularly when it comes to purchasing durable goods.’’ In fairness, there was a token reference buried in the long statement indicating that the automotive sector should see some recovery at some point in time.
Encouragingly, BMW reduced inventory by a further 7% and now holds less than 80% of the pre-Lehman Brothers level. This is good for its prospects in a lower sales environment, as there will be less pressure on the company to cut prices further. It is positive for bondholders as it increases BMW’s ability to repay debt obligations. It is not however the action of a company confidently striding forward to take advantage of an economic recovery.
Caterpillar and BMW are just two examples – a cross-section of 55 industrials across the US, UK and Europe shows that inventory reduction in the second quarter continued at a hasty pace, well in excess of the first quarter reductions. Headcount cuts signal similar caution.
Risks to credit declining
Certain event risks are now low relative to the period before the credit crunch. One of the more significant fears in the bond markets pre-June 2007 was that the private equity buyers stalking the markets with huge purses of cash would buy a corporation, lever it up exponentially and leave bondholders with a weakened, leveraged shell of an obligor. In some cases, bondholders were able to buy bonds that had clauses that would enable a put at par if that event occurred. For the vast majority of holdings, there was no such protection.
That fear is now significantly reduced, as is the concern around more traditional acquisition activity. At some point corporate acquisitions will pick up, as confidence increases and those firms with large cash piles begin to take advantage of relatively low asset prices. We do not think that this will occur in a meaningful way until banks are further down the road to ‘normal’.
One could argue that relying on the insight and foresight of corporate managers may not be very prudent, considering that this strategy would have been an absolute failure back in early 2007. To address that concern, it is worth considering one substantial safety net.
Policy makers may be the hidden ‘automatic stabilisers’ on the yet to be seen recovery juggernaut. They are already under pressure to resume business as usual activities. For example, it is difficult to imagine the US Congress agreeing any further liquidity or stimulus following a 40% rebound in the Dow and chat of a resumption of huge bonuses at the various beneficiaries of government rescue packages.
It is much easier to see Congress pressuring the Fed to cease at least some of the acronym-veiled programs intended to stimulate securitisation, mortgage provision and asset price rises. Mainstream newspapers such as the New York Times are beginning to host this sentiment on their opinion pages. The more radical House members, however ill-informed they may be, have been consistently vocal on this point. A premature withdrawal of such measures would have a rapid, substantial cooling effect on any economic overheating.
Conditions right for debt
A soft economic environment, accompanied by management prudence is very good for credit. Investment grade companies entered the recession in historically sound condition, with low debt levels (away from the banking sector) and a fairly high degree of labour flexibility due to the long-term waning of influence of unions in key economies.
The main risk to the scenario would seem to be underestimating the strength of recovery and the probability of higher inflation. Reading the political tea leaves in the US, Europe and UK, it seems that governments will very quickly remove stimulus if they see anything like overheating.
Slow growth seems the most likely scenario, and investing in the debt of well-managed investment grade companies should continue to deliver significant excess risk-adjusted returns.
Gregory Turnbull-Schwartz is a fixed income investment manager for Aegon Asset Management
