From BofA's Michael Contopoulos
You don’t need a recession
Over the last several weeks much has been made of the near-term risks of recession. Some have argued that the widening in high yield is suggestive of an economy that is ready to roll over and with the manufacturing sector already reeling and China growth concerns growing, we think the fears are well justified. However, given we are not economists we ask whether a recession is a necessary backdrop for further weakness in high yield. In our view, the answer is no.
Consider that between March 1998 and December 2000 our high yield index widened from 283bp to 916bp during a period of US economic growth that averaged 4.2%. Furthermore, as growth slowed to just 1.1% over the next 8 quarters, high yield averaged about 873bp during that time. In other words, the widening in high yield occurred in the lead up to economic weakness, not during. Defaults and the economic cycle, however, seem much more aligned; the 12-month default rate leading into the end of 1998, 1999 and 2000 was 3.4%, 6.3% and 6.4% respectively. It wasn’t until 2001, after spreads had blown out, that default rates increased to double digits.
As we look at the index in more detail, we see that the non-commodity portion of high yield today compares favorably to the ex-Telecom index in early 2000. Although this portion of high yield eventually widened to 1000bp, the bulk of the selloff occurred before US growth slowed meaningfully. Should non-commodity spreads today go to levels we saw non-Telecom go in late 2000, we could see as much as 100bp of widening before reaching a temporary peak. Coupled with a couple points of loss due to default, and it’s not difficult to envision another year of negative total returns without a contraction in GDP or a spike to double digit default rates.
What keeps us up at night, however, is a situation where history is little indicator of what’s to come. Although there is no doubt that we do not need to have a recession in 2016 to experience further high yield weakness, we are concerned that this cycle could prove to be not only different, but more severe than past cycles. The economic slowdown earlier this century was a modest one and was associated with a Fed that had significant policy tools. Should a slowdown today be swifter and deeper, more akin to 2008 than 2002, we are concerned about the ability of the central bank to create enough monetary stimulus to stem a crisis.