‘Morphing Into A Structural Shift’

For all the celebration (and simultaneous derision) around the Fed’s success in helping to drive corporate borrowing costs to record lows, credit is still wide to equities, suggesting a structural shift.

The Fed’s backstop for investment grade credit and fallen angels (and especially the central bank’s purchase of credit ETFs), brought out the “moral hazard” calls. For months, everyone from serious market participants with an actual, financial stake in the matter to netizens with no discernible connection to the debate whatsoever, decried the “nationalization” of the US corporate bond market.

When pressed, most serious observers admitted that the Fed’s corporate credit facilities played a critical role in averting what may have otherwise morphed into a catastrophe. But that reality didn’t stop finance-focused social media and various bloggers from accusing Jerome Powell of literal crimes (and worse).

The most ridiculous aspect of that cacophony wasn’t even the scope of the allegations, but rather the extent to which most of the people making them had absolutely no reason to concern themselves with mispriced credit spreads.

I don’t want to be overtly condescending. Everyone is entitled to an opinion on everything in America, but I think, after the past four years, that entitlement may be something we need to revisit as a society. There’s a reason you don’t scream “Fire!” in a crowded theatre when there’s no fire, after all.

Anyway, there are myriad good reasons to be concerned about the side effects of the Fed’s backstop for corporate credit, not least of which is rising leverage. Between them, IG and HY borrowers tapped the market for some $2.2 trillion in 2020.

Needless to say, all of that debt may not be serviceable in the event the recovery from the pandemic doesn’t prove to be as robust as optimists hope.

Concerns about the “scarring” effect and, likely, the sustainability of the debt incurred over the past 10 months, may help explain why credit is still some 10bp too wide versus stocks.

“As the year is winding down, hysteresis in risk assets that started in the early days of the crisis, is gradually morphing into a structural shift,” Deutsche Bank’s Aleksandar Kocic said Tuesday.

While he notes that “correlations have been restored” there’s still a “dislocation” in credit versus equities “when compared to the pre-crisis period.

“Given the run equities have had in the second half of this year, credit remains… too wide, despite all the counterforce of the Fed purchases and low rates,” Kocic remarked.

This is something to keep in mind, especially given uncertainty around the future of the Fed’s corporate bond-buying programs after the public “spat” between Powell and the outgoing Steve Mnuchin earlier this month.

As Kocic went on to reiterate, the pandemic’s “long-term effects on aggregate demand have not been sorted out yet, especially their influence on the corporate sector and credit.”

While one would like to assume that a rebound in profits and robust top line growth (as vaccines restore economic normality in 2021) will make what otherwise seem like unsustainable debt burdens look more manageable, there is no guarantee of that.

“Questions like which businesses would survive the crisis, how many people will lose their jobs permanently, how will they pay their rent (and how will their landlords pay their liabilities), how much will they be willing to travel, consume, what services will they use, or how the banking sector will respond to all that, remain still largely out of grasp,” Kocic reminded folks.

He delivered similar cautionary remarks earlier in the pandemic. The Fed will, of course, attempt to forestall the kinds of chain reactions described by Kocic, but even the central bank’s “tweaked” mandate only gives monetary policy so much leeway to address structural problems. The rest is up to fiscal policy or, more to the point, lawmakers.

And, as Kocic suggested earlier this month, it all may ultimately prove inadequate. “It appears as if there is an urgent need to reconfigure the whole socioeconomic system in a way that harmonizes with the needs of both the economy and society,” he said.