By John Fekete, Managing Director and Head of Tradeable Credit at Crescent Capital
In the “late” phase of a business cycle, we expect rising inflation and a tight labor market will decrease profits, leading to higher interest rates. Economic activity often reaches its peak, while growth remains positive but slows, as we have seen over the past two years. Now it appears we are about to enter a new phase, ushered in by the Fed’s policy pivot and 50 basis-point rate cut in September. This new phase is expected to be characterized by further declining interest rates, looser financial conditions, and strong credit growth. We believe corporate expansion is more likely than recession, albeit at a slower, more sustainable pace of growth.
At the August policy symposium In Jackson Hole, Fed Chair Powell gave his clearest indication yet of the Federal Open Market Committee’s readiness to cut rates in 2024. Risks have shifted away from surging inflation to the potential downside posed by a cooling labor market. Investors and central bank officials are growing concerned about the health of the world’s largest economy after more than a year of interest rates at 5.5%, the highest Fed Funds target in two decades. Cracks have appeared on the employment front, prompting fears that high rates pose a new threat to the economy. “The time has come for policy to adjust,” according to Powell. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. A slowing, but normalized pace of growth is no accident. It is the outcome the Fed intended as it began hiking interest rates in 2022 to combat hyperinflation. Higher borrowing costs tempered demand and supply chain disruptions largely cleared, bringing inflation below 3% for the first time in three years without a sharp rise in unemployment claims.
While the unemployment rate has risen to 4.2%, it remains low by historical measures. The increase in the unemployment rate has occurred alongside an expansion in labor supply on the back of the 2022-2023 immigration surge rather than a sudden drop in labor demand. More than 3.7 million jobs were filled by foreign-born workers between 2022 and 2023 according to the Bureau of Labor Statistics, as U.S. Consulates worked through the backlog of visa applications that developed during the early days of the COVID pandemic. This influx has been key to the rise in the U.S. labor force and suggests labor market indicators may not follow historical patterns.
The combination of higher unemployment and lower inflation strengthened the case for rate cuts. Mr. Powell’s remarks after announcing a 50 basis-point cut on September 18 were closely aligned with our views on a soft landing. The Fed sees the economy growing at about 2% per year, disinflation is on track, and unemployment is likely to stabilize at about 4.4%. Mr. Powell’s remark, “the US economy is in a good place, and our decision today is designed to keep it there,” is encouraging indeed. In our view, September’s 50 basis-point move was an “insurance cut” made while the economy is solid to help limit the chance of a downturn. The Fed’s “put” is in play, which should be a good setup for credit markets.
In a commentary published earlier this year titled, “Clip Coupons and Carry On,” we noted conditions were favorable for investors to earn attractive carry in 2024 with relatively low volatility. Year-to-date performance through August 31 has been strong for high yield bonds, leveraged loans, and CLO debt, with returns of 6.3% (ICE BAML USHY Index), 5.8% (Morningstar Leveraged Loan Index), and 5.6% (JPM CLOIE), respectively. Each of these asset classes could produce high single-digit returns in 2024 assuming current coupon rates prevail for the balance of the year.
The threat of an earnings recession for leveraged issuers has shadowed the Fed’s higher-for-longer rate path, but earnings were healthy enough in the first half of 2024 to blunt the damage to credit measures as higher debt service costs were largely offset by robust earnings growth. Leveraged loan borrowers showed revenue and EBITDA growth – 2% and 4%, respectively – for the 15th straight quarter from April to June, according to LCD Pitchbook. Interest coverage ratios remain healthy for most loan issuers. Just over 77% of the issuers in LCD Pitchbook’s universe had interest coverage greater than 1.5x, up from 73% in the third quarter of 2023.
U.S. defaults are falling, and recovery rates are rising.
According to Deutsche Bank, the dollar volume of high-yield bond defaults fell by 0.3% to 2.8% in July, the lowest level in over a year. The dollar volume of leveraged loan defaults fell by 0.1% to 6.4%, with distressed exchanges still comprising roughly 64% of all defaults. Speculative grade recovery rates are also rising. Senior unsecured bond and first-lien loan recovery rates now stand at 39% and 62% according to DB, the highest since March and April 2023, respectively. This positive momentum should continue as the Fed cuts rates. Recent default activity, including distressed exchanges, has largely been concentrated in a small group of sectors including telecommunications, media, and healthcare.
What does the Fed policy pivot mean for credit? Rate cuts should result in lower interest expense and higher free cash flow going forward, as nearly two-thirds of the public and private leveraged finance market has floating rate coupons. These factors are likely to be a tailwind for credit, resulting in higher interest coverage ratios and potentially fewer credit rating downgrades or defaults in the next phase of the business cycle.
A soft landing is not bad for credit. We see rate cuts as positive, as they mean investors can take advantage of a carry-friendly environment with modest signs of corporate or consumer stress. The technical backdrop appears positive for credit spreads, with volatility declining after reaching a high in early August while considerable cash sits on the sidelines waiting to rotate into the market.
We see three potential risks to our outlook:
1. The Fed is too measured in normalizing policy and slow to bring the Fed Funds rate closer to neutral, resulting in excessively restrictive monetary policy and increasing the risk of recession.
2. The potential for climbing consumer delinquencies and defaults to undermine spending, particularly for low- and middle-income households.
3. The impact on regulations, corporate earnings, and capital investment following the November election.
Against this backdrop, we believe investors can benefit from disciplined sourcing, underwriting, and portfolio construction processes that remain consistent and that can help generate high income with minimal default risk.