Highlights

• There Will Be Blood…and More of My Favorite Themes for 2016. California’s early 20th century oil boom depicted in the 2007 film provides this year’s lead theme highlighting the risk outlook: collapsing commodity prices’ risk of spillover into the broader outlook. Certainly, there is already blood in the energy sector. Compared to the prior year, commodity sectors in 2015 saw a quadrupling of defaults. Though much of these risks are priced into credit spreads, the prospects of even further erosion keep us cautious on credit for 2016.

• The Credit Cycle Leads the Business Cycle. Heard this one before? “As we see no signs of recession…” the advice states invariably to “keep on dancing.” But you never see the recession coming—it’s always a surprise. And that generally is because you are looking for its signs in all the wrong places. Using economic forecasting to predict the credit cycle gets it backwards because the credit cycle predicts the business cycle, not the other way around. Unique for this cycle, the Federal Reserve’s reliance on the “Portfolio Balance Channel” increases the macro vulnerabilities.

• Promises, Promises. The Fed promises “only gradual increases” in the federal funds rate and the market believes an even more gradual path than most Federal Open Market Committee members project. As the song refrain asks, “why do I believe?” Conditional on its forecasts for economic conditions, the Fed promises a “gradual” normalization. But the Fed has been a poor forecaster. Two-sided risks to the Fed’s outlook lie in faster-than-expected wage growth signaling an even tighter labor market or oil’s spillover effects halting normalization.

• Preference for preferred. In what is an otherwise defensive strategy for 2016, what do we like? Though also vulnerable to a general risk off and especially an equity market correction, we prefer to take our higher risk income allocations by going down the capital structure of higher quality names.

• And More of My Favorite Themes. Non-USD bonds look better positioned vs. last year given the significant repricing of the dollar and move to neutral from underweight. Treasury Inflation-Protected Securities’ (TIPS) valuations look attractive but near-term headline commodity inflation risk keeps us neutral. Downside risks plus a very gradual Fed improve the attractiveness of gold. And the back end of U.S. duration looks preferable given Fed normalization and deflationary tail risks. The U.S. consumer, residential and commercial real estate sectors stand far removed from the epicenter of this credit cycle, leaving their mid- and higher-quality securitized exposures a good source of carry, but we limit their allocations due to their relative illiquidity. Finally, we see the outlook for stocks vs. bonds more balanced than in prior years given extended stock valuations and the significant repricing of risk in bonds.

There Will Be Blood

California’s early 20th century oil boom depicted in the 2007 film provides this year’s lead theme highlighting the risk outlook: collapsing commodity prices’ risk of spillover into the broader outlook. Commodity and credit risks dominate the risks to the benign base case for 2016. That base case sees stabilization and recovery in commodity prices, and along with it broader financial market stability, reversing the losses seen in credit sectors most heavily exposed to the commodity sectors. The tail risk—that this stabilization fails to materialize —grows the longer and lower commodity prices fall and represents a meaningful risk to the consensus benign outlook.

The Base Case For 2016: Low Growth, Low Returns And Low Risk…

Figure 1 below highlights the summary of consensus economic, interest rate and FX forecasts for 2016, along with the variability around these forecasts. Generally, the consensus view holds stable U.S. growth, with growth in Europe and Japan offsetting emerging markets weakness, increasing but still low inflation, modest increases in interest rates and continued dollar strength.

…And Consensus Risks

Similar to the base case, the consensus risks to the outlook coalesce around two scenarios. The first, and the focus of our lead theme, is the continuation of last year’s China, commodity and credit concerns. On the other side of the risk distribution is rising wage inflation in the U.S. fueling fears the Fed is behind the curve in normalizing interest rates. Figure 2 to the right summarizes Core fixed income returns under these scenarios.

The base case benign scenario shows another year of low expected returns for the Core fixed income category. The tail risk scenario, while significantly negative for credit returns (e.g. High Yield declines 12% under this scenario) shows the best scenario return for Core, clearly as the duration benefit under the extreme tail event in Treasury, Government and Mortgage sectors outweighs the losses in credit.

 

That scenario assumes a sub-2% Treasury rate and certainly were that to go even lower the resulting benefit to fixed income would be higher. On the other side, fixed income suffers its long expected negative return, dropping around 1.5% if faster wage growth and inflation fears lead to rising interest rates that erode the benefit of fixed income. That scenario presumes a slightly above 3% terminal 10-year rate (3.2%) and understates the potential losses were rates to rise beyond that.

So what scenario will it be? Today, we put about 10% odds on the inflation scenario, and 30% odds on the deflation scenario, leaving 60% for the baseline. But those baseline odds drop—and the deflation odds rise—for every continued drop in commodity prices.

Triple C: China, Commodity And Credit Fears – Idiosyncratic Or Systemic?

Fears over China, commodity prices and credit greeted the first week of the New Year. Becoming acute last August and resurfacing again in December, the nexus of China economic concerns manifest in a falling value of the renminbi vs. the dollar, falling oil and commodity prices expanding fears of credit defaults. Together these accounted for the negative returns in High Yield credit in 2015. In the aftermath, investors grapple with the key question: Are these issues isolated and idiosyncratic, or at least small enough to remain benign, or might they signal something more troublesome to the overall outlook?

The answer depends on the consequences of the collapse of the China-growth-fueled commodity bubble. And while the debate rages on about just how, where and when commodities will find their “floor,” Figure 3 reminds us of just how extended that bubble was and how far its deflation has already come.

Not Falling Prices, But Falling Faith…

The most significant event of 2015 in our view is the collapse not in commodity prices themselves (for that had already happened in 2014), but rather the collapse in the belief in the recovery of commodity prices. At the beginning of 2015, the year-end 2016 oil price expectation held around $80 to $90, and today it stands at $55. As highlighted in Figure 4, the implication of undermining the belief in the recovery of oil is to introduce the realization of its consequence—default.

Figure 4 highlights the relationship between falling oil prices and falling prices of High Yield energy bonds (both first and second lien bonds). But unlike when oil first hit $50 back in December 2014, when it hit it again during the summer of 2015 expectations for future oil prices (in the figure indicated by the median year end 2016 Brent Forecast) collapsed. At the beginning of 2015, $50 spot oil was still associated with expectations for a rebound to $85. When oil hit $50 again in the summer of 2015, expectations for rebound collapsed.

…Broaden The Impact Of Collapsing Commodities

And it was the collapse in these longer-run commodity price recovery expectations that were associated with the broadening of commodity concerns outside of the relatively small independent energy production sector of U.S. High Yield. The 20 point declines that occurred in September 2015 in the bonds of Petrobras, Glencore, Anglo American and Freeport- McMoRan are not the small, independent energy producers that dominated the declines in High Yield, but large, global and currently (or formerly) investment grade-rated names held broadly in investor portfolios. The significance of this shift is illustrated by the fact that investor losses in 2015 on these four names alone stand just under the entirety of losses borne by investors in the entire high yield energy sector.

Denial highlights why financial markets did not immediately in 2014 or in the beginning of 2015 price in the significance of such a substantial collapse in commodity prices. If “home prices can only go up” was the slogan of our last bubble, “commodity prices can only stay up” was the slogan of our latest. As that bubble of beliefs bursts, creditors cut exposures and issuers unable to service debts with falling revenues are now unable to delay that service with debt rollovers. So fears of default in 2014 turned to realization with a quadrupling of defaults in commodity sectors in 2015.

The Oil Spill (Over): The Case For Systemic

Which brings us back to our original question: What are the signals from the credit markets telling us? Here, we make the case for the systemic risk possibilities. As such, this represents the risk to the more benign outlook. Stabilization of commodity prices should limit this risk scenario, but as long as the outlook for commodity prices remains uncertain, the greater the potential systemic spillover effects.

 

Consider that the consensus oil price forecast for 2017 stands at $60. The consensus view on oil sees stabilization and eventual rebound. But as the box nearby outlines, the risk scenario—one to which we ascribe higher likelihood than the market—suggests further declines. But how can declining commodity prices which function as a boon to consumption be bad for the outlook? Indeed, falling prices will help support the consumer and the economic outlook— eventually. But before we can realize those benefits, the financial market vulnerabilities from increasing defaults in commodity sectors risks spreading to a broader withdrawal of liquidity in credit markets.

Crude Realities

Despite crude oil prices reaching their lowest levels since 2009, significant downside risks continue to shape our bearish view on the commodity and on assets dependent on a rebound in energy prices. With OPEC production at near all-time highs and geopolitical and budgetary considerations forcing the key OPEC swing producer, Saudi Arabia, to continue its policy of full production for maximum market share, oil continues to be significantly oversupplied. Weighing on markets more recently is the anticipation of the removal of Iranian sanctions, as fears of 500,000 barrels or more per day can return to global markets as soon as the first quarter.

In the U.S., while rig counts have fallen precipitously and total U.S. oil production has declined from its peak, shale oil producers have done their best to cut costs and maintain production at price levels below what was once thought their breakeven points. In fact, recent estimates put much of the Eagle Ford basin, for example, profitable below $40. Companies have benefited from much cheaper operating costs as a surplus of equipment and labor have lowered the cost of production, and have also continued to increase productivity by drilling wells in more favorable formations. Investors also fear a surplus of drilled but uncompleted wells waiting to be turned on and a wave of futures hedging by producers as soon as crude oil prices rebound—keeping a long term ceiling on how strong a rebound can be.

The glut of crude oil has led to rising inventories around the globe and the increasing utilization of storage capacity. Despite strong refinery demand for crude oil and strong consumer demand for gasoline, the price elasticity of demand has not been enough to offset the glut of supply. Coupled with the potential for a stronger U.S. dollar this year and OPEC’s desire to increase market share, it translates into a very slow rebalancing process. When commodity markets are oversupplied and inventory levels are high, the adjustment level must come from price—and that signals to us continued downside at least for the first half of 2016.

A Rolling Loan Gathers No Loss…Until It Stops Rolling: How A Lack Of Liquidity Spreads The Credit Cycle
All credit cycles begin with concentrated risks—last cycle it was housing, the one before that was telecom, media and technology. When the concentration of credit risk is big enough, the spillover effects of default losses are hard to contain. With one-third of all High Yield debt issuance since 2010 and one-third of all EM corporate debt outstanding coming from Energy, Metals and Mining, today’s concentrated risks are certainly big enough.

And liquidity—or the lack thereof—is the reason why the concerns in credit are not limited to these commodity related sectors. When considering the fundamental cause of default it is always liquidity, summarized by one of our all time favorite themes, A Rolling Loan Gathers No Loss. When default risk spikes in one sector it leads to a withdrawal of liquidity in other potentially vulnerable sectors and issuers.

Beware Of Bifurcation

Do those nearly 9% high yields look attractive? Look a bit closer and you will see they do not exist. That average yield reflects a bifurcated credit market: 6% yields in the “safe stuff” but closer to 12% in sectors with real default risk. The bifurcation of credit markets are again telling you that the withdrawal of liquidity (aka credit rationing) is exactly what is happening. Consider that in 2015 CCC credit in HY fell more than 12% while BBs lost only 1%. While outflows remained benign, fears of outflows led to this rationing of credit.

We see a similar bifurcation in the bank loan market. While the index average fell around 8 points in 2015 to $88, the bottom 20% of the market accounted for almost all of the decline. When liquidity leaves the most vulnerable issues in search of the safest, the perceived safe issuers’ prices can stay stable and today average around $98. But for the bottom 20%—the risky stuff—their prices dropped to an average of around $60. Were liquidity to further withdraw from the market, that $98 average price segment is most at risk.

It is exactly this withdrawal of liquidity from the highest risk issuers that causes the spread of the credit cycle from its initial sectoral concentration. No wonder that historically across the default cycle, half of all defaults come from the CCC sector. When default risks rose in one sector they spread to others through this rationing of credit. And issuers with the most dependence on liquidity for rolling over their debts and funding negative working capital—CCC-rated issuers— end up contributing most to the default outcome.

From Virtuous To Vicious Liquidity: Cognitive Biases Of The Credit Cycle

The ebb and flow of liquidity fueling the credit cycle stems from three fundamental cognitive biases: anchoring, failure of imagination and loss aversion. Anchoring bias—the tendency to use an initial piece of information when making subsequent judgements—contributes to “reaching for yield” behavior that brings a wave of investors’ liquidity in the mid- to late-credit cycle. At this point in the credit cycle yields are still relatively high, but as the credit quality of the surviving universe of credits improves (both as a function of having defaulted or restructured the weakest parts of the market and as a function of improvements in the business cycle) more liquidity coming into the market improves the refinancing capability of companies. This further reduces default risk and further improves credit profiles. In this virtuous part of the credit cycle, liquidity and default risk all reinforce each other to lower defaults and tighter credit spreads. Anchoring bias contributes to investors’ belief that the virtuous liquidity cycle will always be the case. This is best illustrated by the consensus view typically found in the middle of the credit cycle of protracted low 2% default rate expectations.

 

Ignorance Breeds Confidence; Knowledge Breeds Doubt

Next, “failure of imagination bias” reinforces the anchored view to 2% default rates drawing even more investment into the sector. This bias means most investors never spot what ultimately causes the credit cycle to turn. The shift is always a surprise. The consensus never saw the internet collapse. The consensus never saw the housing collapse. And the consensus never saw the commodity collapse.

Fear Trumps Greed

Finally, with the collapse now revealing to these investors the faults of their first two fundamental cognitive biases, loss aversion—the preference to avoid losses over making gains— kicks in. This one stems from the belated realization that historically, two-thirds of all default realization over a typical 7- to 8-year credit cycle occurs in only 3 of those years—the peak and the years surrounding it. The realization that the peak of credit losses is now just around the corner leads investors (particularly those whose participation came late in the credit cycle, revealing a preference for lower risk investing) to do what can be seen in this light as an entirely rational decision: in order to avoid those future defaults and losses, they sell. And in so doing they provide the very catalyst necessary to create the credit cycle they fear—the withdrawal of liquidity. And so begins the vicious part of the credit cycle: falling liquidity leads to fears of default which leads to a further withdrawal of liquidity.

Cognitive Bias Combines With The Supply Side “Minsky” Cycle

The above characterizes the behavioral underpinnings of the demand side of the credit cycle. That combines with the more familiar underpinnings of supply known as the “Minsky” theory of the credit cycle and its three stages—hedge, speculative and Ponzi. The combination of both supply- and demand-side behavioral factors creates the credit cycle history of peak to trough defaults depicted in Figure 5.

But How Much Is Already In The Price?

Despite such concerns, however, clearly the market reflects some of those concerns. As a result we upgraded late last year our underweight stance on High Yield to neutral, reflecting this better balance between risk and reward. We anticipate another tactical allocation strategy for High Yield (and relatedly other higher credit risk segments of the market) for 2016. But the commodity price bust has clearly ushered in the next credit cycle, making the outlook for returns more challenging and arguing for neutral to underweight allocations rather than the overweight allocations we had favored when the credit cycle was not as long in the tooth.



The Credit Cycle Leads The Business Cycle

A key lesson from the last crisis was that asset price bubbles bursting can create recessions. The collapse in the credit market for housing-related credits cascaded risks into the financial system, threatened its collapse and caused a credit crunch that led to the Great Recession.

Today, the risks posed by China, commodities and credit appear not to rise to the level of the 2008 global financial crisis. That level of virulence stemmed from hitting both the heart of the economy (the consumer) and the heart of the financial system at the same time.

Rather than “Great” we see more a “garden variety” type of credit cycle. But even garden variety credit cycles can lead to business cycle recessions and significant implications for financial markets. And conventional wisdom misses the fact that credit cycles do not follow the business cycle, they lead.

Former Fed Governor Jeremy Stein recently highlighted the economic and credit market evidence supportive of these views long held by many participants in credit markets. This work reminds us that though the global financial crisis is the most recent and perhaps strongest example since the Depression, it is by far not the only example of credit markets leading the business cycle. For virtually every business cycle finds its spark in a credit cycle. The specific manifestation may differ, and certainly as our credit intermediation has moved from bank to capital markets (with the 2008 crisis the capstone in this transition), the form has evolved. But the causality is clear and its consequences profound: if you are looking for signs of the next credit cycle in today’s economic data you have got your model backwards.

Figure 6 above highlights the main conclusion exhibit of Stein’s paper. Here the authors looked at credit market indicators—summarized as “credit-market sentiment”— compared to business cycles since 1920.

The x axis highlights “credit market sentiment,” a measurement of conditions in the credit markets, lagged by two years. Positive values reflect ample access to credit and low relative costs of credit. The y axis shows the business cycle condition. Importantly, the authors find that credit market sentiment today is related to business cycle outcomes two years hence. Now note the inverse relationship. This highlights that today’s boom in credit is followed by economic bust two years later. And considering that the peak of “credit-market sentiment” appears to have occurred in 2014, it suggests by this crude historical analogy an economic downturn in 2016.

 

Of course, Stein cautions us not to read too much into this historical relationship for forecasting. Clearly many other factors are at work. Though Stein does not attempt to describe how those factors work—how the transition from credit cycle to business cycle works—the historical evidence clearly supports the notion that changes in the credit cycle lead the business cycle.

So How Might Changes In The Credit Cycle Lead The Business Cycle?

We have already argued that the spread of commodity risks to the broader credit cycle might result from undermining liquidity as fears of greater default risks in commodity-related securities spread at lower and lower commodity prices.

How might that risk spill over into a broader business cycle risk? Certainly the tightening of credit outside of commodity sectors appears the obvious transmission channel. Yet ample global central bank liquidity might be argued to be more than offsetting. Particularly in the U.S. market, improving access to liquidity for consumers in housing and a greater willingness to use credit for consumption given household balance sheet repair might offset and even dominate any credit concerns from the corporate sector. Certainly given U.S. consumers’ larger role in growth this argument has even greater merit to offset the corporate default and commodity concerns.

However, the consumer channel itself could be the channel through which the commodity concerns spread. Unique to this cycle, the transmission of monetary policy has relied to a great extent on a novel source, “the portfolio balance channel.” The term—coined by Ben Bernanke—reflects the fact that the Fed has relied on financial market asset inflation to do the transmission of accommodation into stimulus: reflating financial assets reflates confidence and this leads to greater spending. Figure 7

But what works on the way up can fail on the way down. Consider the support for stock prices stemming from corporate buybacks. Those are fueled by debt markets.

Close the debt markets and you close the buybacks. Investors reward management for buying back shares on the way up. On the way down they get punished. Take that support out from underneath the stock market and you remove the only net source of demand for stocks.

Promises, Promises

For completeness, we turn now to the other risk scenario where rather than the deflation risk just described, inflation expectations grow faster than expected. In the case of stabilizing commodity prices, the outlook for headline inflation quickly becomes one of rising inflation. That is merely the artifact of past commodity declines washing out of the data. But the strong payroll creation in U.S. labor markets suggests the potential tightening to the point where wage gains might begin to accelerate. Under such conditions, the market focus might shift from the deflation concerns brought about by China, commodities and credit losses to inflation. Though the Fed promises a “gradual” normalization, that promise is conditional on its economic forecasts turning out to be correct. But the Fed has been a poor forecaster. Two-sided risks to the Fed’s outlook lie in the low likelihood outcome (in our outlook) of faster-than-expected wage growth signaling an even tighter labor market and a need for faster normalization, or the case outlined earlier where oil’s spillover effects halt normalization.

 

“New” Divergences

Non-USD bonds get an upgrade to start 2016, our sole change to begin the year. Significant dollar appreciation as well as appreciation expectations provide a more balanced outlook for FX returns (a significant detractor in 2015). More accommodative monetary policy abroad furthermore raises the attractiveness of non-USD investments for 2016. Figure 8 below captures the notions of a more uncertain outlook for the dollar in 2016. Recall  that the “divergences“ theme in 2015 was a consensus view that diverging monetary policy with the Fed tightening while the ECB and the BOJ expanded their accommodation would lead to a stronger dollar. While that played out in 2015 with the trade weighted dollar increasing by 11.8%, in 2014 it had already increased by 10.5% anticipating those divergences. Hence, as we look ahead to 2016 much of the divergences expectations could be argued to already be in the price. The figure supports this notion by highlighting how in many past tightening cycles, the peak of dollar appreciation was marked by the first tightening in a currency version of “buy the rumor, sell the news” outcome. However, in the big dollar valuation cycle of 1980 we saw substantial further valuation improvement after the Fed tightened. The historical record is thus mixed when it comes to the dollar outlook. “Divergences” alone is unlikely to provide the same fuel for dollar appreciation as in past years, leaving a more balanced view for non-USD fixed income investing for dollar based investors relative to past years.

Fixed Income Portfolio Recommendations To Start 2016

Yield curve steepeners and TIPS breakeven inflation strategies likely perform best in the above scenario of inflation surprising to the upside. However, given the lower likelihood we attribute to this scenario, we see that more as a risk and currently position neutral TIPS while favoring a flattening yield curve outlook when considering the full year outlook. Rounding out our other recommendations to start 2016, most carry over from the end of 2015. We continue to favor credit exposures to the U.S. consumer and to U.S. residential and commercial real estate. Partly this is due to their relative remoteness from the epicenter of the current credit cycle: China, commodities and, more broadly, EM. That leads us to treat credit exposures defensively. But a repricing wider of many of these sectors improves relative value and we start the year generally neutral across High Yield, Bank Loans and IG but anticipate moving tactically between neutral and underweight until a greater realization of the credit cycle increases the value offered by these sectors. We additionally continue a defensive stance on liquidity favoring the higher liquid value of global rates positions vs. credit. That makes non-USD bonds more attractive, and despite the headwinds of a potential for further dollar strength in 2016, much of that strength already occurred and is reflected in the price. Furthermore, developed market non-USD bonds benefit from the more accommodative monetary policies of the European Central Bank and the Bank of Japan. Finally, given our more cautious stance on credit, for sources of income we prefer going down in capital structure in higher quality sectors. That highlights preferreds in the corporate sector as a better source of yield to start 2016.


Jeffrey Rosenberg is managing director and chief investment strategist for fixed income at BlackRock.