Reminder: do not to conflate weakness in stocks with weaker credit quality
All investment markets are futures markets. According to two of the three theories of market efficiency, what has occurred in the past has been priced in to some extent. This important concept should be remembered when fixed-income investors look at the weakness in the equities markets. The weakness in the stock market could be related to a number of factors including the Fed’s approach to battling inflation, concerns with future consumer behavior, the war in Ukraine, and supply chain issues. All of these reflect significant risks to the future value of both equities and fixed-income securities, but the tremendous loss in value of major indices is also due to some of the unique attributes of the index composition. High growth technology stocks account for 25-30% of the S&P 500, and they have experienced some of the largest declines in share price. Tech stocks are considered growth stocks and tend to fall out of favor during periods of Fed tightening. This results in 1) a higher discount rate for future earnings, meaning a dollar earned in the future will be worth less than it was with a lower discount rate; 2) lower projected revenue growth which impacts increases in future earnings and cash flows; and 3) a lower terminal multiple, potentially the most meaningful input as it gives a value to earnings in perpetuity. Despite the reported earnings growth in the most recent quarter, the terminal multiples have been reduced to account for the more dour future projections. This is the concept of multiple compression in the stock market.
The concept of multiple compression is not generally applied to fixed-income securities. As a result, fixed-income investors will focus more on the credit quality and relative value of a security. It is important to note that credit quality considers the macro and competitive environments. Downgrades will often occur due to a distinct issue with a company, not because of a weaker or uncertain macroeconomic climate. This is not to say that an industry facing substantial headwinds will not see wholesale downgrades, but no high-grade industry is currently facing such difficulty. Suffice to say, fixed-income investors should remember weakness in equities does not necessarily mean there is cause for concern about credit quality. Our team uses a strict fundamental research approach to ferret out the noise from the equity market and attempt to see deteriorations in credit quality before the market does.
Investors see bears looming over the fixed-income market
According to the May 2022 Bank of America U.S. Credit Investor Survey, investors are in their most bearish positioning since 2020. The survey highlighted that inflation is still the number one concern amongst credit investors, but recession risk has moved into second place compared to dead last in January. Most expect wider spreads over the next three months despite less supply while investors are also expecting a deterioration in credit quality. One bright spot is that respondents see more value in spreads with most seeing spreads as fairly or undervalued which could lead to some tactical opportunities for managers. Given the rapidly rising rate environment and persistent inflation, it is unsurprising that investors have turned so bearish. During times like this where quality deteriorates and concerns reverberate around the market, the onus is on credit teams to manage the risk and stay ahead of both negative and positive trends.
China’s economy falls further into distress as the effects of COVID lockdowns take a toll
China is now experiencing a worse economic slowdown than the initial COVID outbreak in early 2020. Consumer spending and factory output both decreased in April, while infrastructure investment drastically slowed according to China’s National Bureau of Statistics. Unlike the U.S., China’s jobless claims appear to be moving in the wrong direction, sitting at a 2-year high of 6.1%, as the country tries to survive and navigate its self-induced and stringent pandemic measures. The ongoing lockdowns and lack of stimulus going directly to households are creating a formidable combination that is suppressing consumer demand. As evidence, April retail sales were down 11.1% from last year, a second straight monthly decline representing the largest contraction since March 2020. Industrial output measures are also being hit with April production down 2.9% from the previous year. The automotive sector is receiving the brunt of it with zero cars sold in Shanghai in a whole month and the entire sector down 43.5% by volume as policymakers implement sweeping lockdowns across the country’s production facilities. These factors are creating a perfect storm that seems difficult to overcome. Citi cut its year-over-year Q2 GDP forecast to 1.7% from 4.7% and its full-year estimate to 4.2% from 5.1%. Like the U.S., China appears to be going through housing struggles of its own with April new home builds and home sales by value down 44% and 47% from a year earlier, respectively.
The interconnectedness of the globe creates immediate ripple effects when a major global power spin into an economic downturn. The U.S. is amid a heated legislative debate of legislature intended to strengthen U.S. competitiveness against China. Prominent provisions of the bill include waivers on tariffs of Chinese imports as well as instituting production independence as it relates to semiconductors. Ideally, this bolsters U.S. high-tech manufacturing and slows the progress made by China. The legislation would specifically reserve $52 billion in subsidies to develop semiconductor manufacturing in the U.S. and reduce dependence on overseas competition from Taiwan. The tariff waivers would ease some pressure on U.S. importers, even though the tariffs were originally designed to penalize the Chinese exporters. When U.S. companies pay duties on imported materials, their operating profits are cut which then makes its way down to the end consumer and exacerbates inflation. As the world sits on the sideline watching China’s attempt to weather its own storm, it remains to be seen if the U.S. will be able to use this as an opportunity to close some of the gaps between us and our commercial rivals.
Strong U.S. dollar has implications for investors, inflation rates, and the hedging activities of global companies
A strengthening of the U.S. dollar has led to the U.S. Dollar Index (which tracks the dollar against six other important currencies) to reach levels not seen over the last two decades. Several factors have contributed to the recent strengthening of the dollar relative to other currencies including rising interest rates, global geopolitical pressures, increasing commodity prices, and slowing growth in other major economies. The value of the dollar has been driven up as foreign investors flock to relatively safe and increasingly higher-yielding assets like U.S Treasuries. U.S. interest rates are significantly higher than many other major economies, leading to increasing yields on U.S. Treasury securities with 10-year notes yielding approximately 2.9% compared to 0.95% for Germany’s bund, 1.8% for the U.K.’s gilt, and 0.25% for Japan’s 10-year government bonds. A more valuable currency makes imported goods less expensive which should somewhat restrain inflation and support the Fed’s efforts to reduce inflation while perhaps diminishing the need for overly aggressive rate hikes in order to curb demand and restrain growth in consumer prices.
Additionally, the increasing value of the U.S. dollar has reduced the profits of global companies that convert foreign currency into U.S. dollars and has led several major corporations, including Coca-Cola and Proctor & Gamble, to cite currency headwinds as operational pressures in their latest earnings reports. In response, many corporations are seeking ways to hedge their profits and reduce the impact of exchange rates. Several global corporations have implemented various hedging strategies including the use of options and forwards to prevent large swings in earnings. While a strong dollar might help reduce the effects of inflation by making imports less expensive, it makes U.S. exports more expensive and less competitive on global markets (exacerbating a trade deficit that reached a new high earlier this year) and can result in volatility of earnings for global corporations.