THE ‘R-WORD’ STRIKES FEAR
Danger seems high, potential damage extreme — but signals could be wrong
Is there a recession around the corner? And does anyone care?
No, seriously. The last “recession” here in Canada wasn’t so bad, was it? Sure, the economy shrank for two consecutive quarters, but just by a little bit. It certainly didn’t feel like a bad recession, at least not for investors. The S&P/TSX composite rose through the first quarter of it, and peaked up two per cent on the year by April 15, 2015.
And while the recovery hasn’t been anything to write home about — well, the point is the economy did recover, marginally. Sort of. In its way.
OK, so this is being frivolous. But the question of recession seems to be on investors’ minds again a lot these days. Not just here in Canada, but around the world. So should we be really worried about it this time?
Markets have been selling off risk assets, piling into safe-haven investments like government debt. European banks were the latest target of the jitters, as concerns over a global slowdown, negative eurozone interest rates, weak growth and bad debts coalesced. The epicentre of concern has been Deutsche Bank, which investors seem to have targeted as the weakest in the herd. Before announcing a bond buyback scheme Wednesday, the stock price of the German financial giant hit a 30-year low.
There are other apparent proof points to the developing recession story, and you can see a bunch of them when you look at credit spreads — the yield difference between corporate bonds and government bonds, which provides a measure of the premium bond buyers demand to take on the higher risk over benchmark.
Bond spreads are, in short, widening. In other words, investors are demanding a higher premium, suggesting a perception of higher risk.
The troubling bit is that this is happening not just in riskier corporate paper (like high-yield debt, especially in the U.S. energy sector, which built up during the oil boom years), but across the wider spectrum of credit.
How blaring is this signal? According to Bank of America/ Merrill Lynch data, option-adjusted spreads in U.S. highyield corporates have risen to more than 860 basis points — well more than double the recent low of 335 bps back in June 2014, and up nearly 200 bps since the start of the year.
It’s a similar story in European high-yield, where spreads have more than doubled since mid-2014 and widened by 70 bps since the start of the year, according to BoA/Merrill Lynch. (This despite the negative interest rate policy of the European Central Bank.)
Yet like I said, spreads have widened not just on the risky end of the spectrum. As of this week, the spread on U.S. investmentgrade corporates was more than double its 2014 low. Even the spread for the bluest of blue-chip debt — AAA-rated — is now at its highest level since late 2011/early 2012, at the height of the eurozone debt crisis.
The worry now is that this broad-based bleed suggests something about the business cycle — namely, that things are about to get really, really bad, with more corporate defaults, and maybe not just among the usual suspects in the energy sector. Certainly, money has been flowing out of equities (insert depressing index performance of your choice here) and pouring into sovereign debt like it’s going out of style.
More than US$7 trillion in government bonds (mostly from Europe and Japan) now comes with negative yield, according to Bloomberg. The U.S. 10-year Treasury yield is well under two per cent, and Canada 10-year government bond yields have fallen more than 25 bps in two weeks. How much should we worry? I am sure there is a historian out there somewhere plotting the curve of the current postrecession period against that of the Great Depression. He might take note of the 1929 crash, the 1933 downturn four years later, and then the deep 1937 recession, and see a pattern not unlike the 2008 recession, the 2011/2012 eurozone crisis and the — well, the potential global recession of 2016.
The risk seems high, the potential damage extreme. If these signals are right, then we wouldn’t be looking at the little chill we got last year, and Canada — weakened by low commodity prices and saddled with high consumer debt — would not escape another global recession unscathed this time.
Of course, the signals could be wrong. Credit spreads have soared, and stock indexes have plummeted, without a major crisis. After late 2011, investmentgrade credit spreads fell for more than two years; the bull market in equities continued, with only minor bumps along the way.
To my mind, what’s going on now in markets looks an awful lot like panic. That suggests there might be buying opportunities for those who have a tolerance for risk that the herd doesn’t.
On the other hand, just because someone is panicking, it doesn’t mean they’re wrong.