Two weeks ago, just before stocks would suffer their biggest losses since the February VIXtermination event amid surging interest rates, Guggenheim’s Global Chief Investment Officer Scott Minerd poured gasoline on the fire with an ominous tweet that caught the attention of the investment community: “Rising rates and declining stocks echo shades of October 1987.”
Rising rates and declining stocks echo shades of October 1987.
— Scott Minerd (@ScottMinerd) October 5, 2018
And while stocks did tumble sharply shortly after Minerd’s tweet, last week’s selloff was not nearly as acute as the Black Monday crash that scarred a generation of traders (that said there are still 2 weeks left in October). Meanwhile, despite the sharp selloff, Minerd has not retracted his crash prediction, on the contrary.
In an extensive interview with Goldman’s Marina Grushin (republished below), the Guggenheim Investments Chairman once again lays out his bearish case, starting with what he believes is the most mispriced asset, i.e., credit, stating that credit spreads are too
tight right now, and noting that “after adjusting for expected credit losses, HY bonds offer minimal value over Treasuries. While carry is reasonably attractive and trailing defaults are modest, a credit investor should not take for granted the ability to liquidate a position when the value proposition changes. The door is always smaller on the way out.”
What is more troubling to equity investors is Minerd’s contention that “turmoil in the credit markets will almost certainly spill over into the equity markets” and that “in a scenario similar to 2001/02, HY spreads could widen by about 800bp or more, which corresponds to a roughly 40% decline in stocks — effectively a retracement to prior technical support levels, the S&P 500 highs of 2007 and 2000.”
And while Minerd isn’t calling for an imminent collapse, saying that he doesn’t think the equity bull market is over yet, he predicts that “an eventual decline of that magnitude looks justifiable to me on a technical and a fundamental basis.”
So if not imminent then when? His answer: by Q2 of 2019 everything will be tumbling:
Corporate credit spreads tend to start widening roughly one year before a recession begins, which would correspond to the first half of next year. But with spreads as tight as they are you aren’t giving up much by starting to reduce risk now. Besides, it takes time to turn a ship around.
Equities will probably peak a bit later in 2019, not least because the Nov-April period tends to be seasonally strong for stocks, especially after midterm elections. That will be the rally to sell. By the end of Q2 next year, I expect risk-off everywhere.
And just in case that’s not enough, Minerd also stakes his reputation on the call that a recession is just around the corner, and the US will see its first economic contraction since 2009 in 2020, when the Trump fiscal stimulus impulse is finally exhausted. But fear not, when that happens, “the Fed will cut rates to zero, employ aggressive forward guidance, and resurrect QE.”
Scott Minerd’s full interview with Goldman’s Grushin is below.
Marina Grushin: What makes you confident that the US economy will enter recession in early 2020?
Scott Minerd: Confidence in our recession call stems from what we’ve observed in past business cycles. Most pre-recessionary periods share a common set of characteristics. They start with an economy growing above potential, putting downward pressure on unemployment. The Fed then raises interest rates—eventually into restrictive territory—to try to limit the growth of imbalances. This is the key recession trigger. Evidence that policy is getting tighter can be seen in the flattening of the Treasury yield curve. Economic activity doesn’t typically slow until a few quarters prior to recession; in fact, growth in the second-to-last year of the expansion is usually fairly strong. We see all of these things playing out right now. The fact that the fiscal impulse is set to fade in 2020 and policy uncertainty will rise heading into the presidential election only adds to my confidence.
Marina Grushin: What assumptions are you making about inflation and interest rates?
Scott Minerd: We’re expecting core PCE inflation to rise over the next couple of years to around 2.25%, partly as a result of cyclical consumer pressures. Tariffs will also have more impact than people think. Not only will imported goods prices increase but competing producers will pad their profit margins by raising prices on domestically produced goods, just as we saw with the 20% increase in washing machine prices earlier this year.
In the face of inflationary pressures and low unemployment, the Fed will have no choice but to forge ahead into restrictive territory. Even former doves like Governor Lael Brainard are now arguing that the short-run neutral rate may be rising, and that policy will eventually need to become restrictive relative to that. In fact, all Fed officials forecast that the terminal rate will be above their respective forecasts of neutral. So restrictive policy is coming in 2019. We therefore see the Fed raising the target range to 3.25-3.50% next year. This will put three-month Libor somewhat above 3.75%. Long-term Treasury yields will likely top out near 3.50%, and the yield curve will invert once it’s clear the Fed is done hiking. We expect a Fed easing cycle to begin in 2020, which will put to rest questions about whether the 35-year bull market in bonds is over. It isn’t.
Marina Grushin: You mentioned the shape of the yield curve as evidence of growing recession risk. Haven’t QE and other factors reduced the curve’s signaling power?
Scott Minerd: I’m not a new-era thinker on this issue. What the conventional wisdom misses is that offsetting factors have negated the Fed’s impact on the shape of the yield curve. QE was more than offset by the combination of large deficits, the decline in market yields and the extension of the Treasury portfolio’s average maturity. Post-crisis regulation also contributed to a steeper curve, as did the Emerging Market (EM) turmoil of 2015-16, which resulted in the liquidation of a lot of FX reserves, i.e. Treasuries. We see evidence that these factors matter when we look at the cheapening of Treasuries relative to swaps in the past decade or the current steepness of the Treasury curve relative to the Overnight Index Swap (OIS) curve. Lastly, term premiums are not as low as the Fed’s models say, so the argument that negative term premiums should affect how we interpret yield curve flattening just doesn’t hold water. But even if you don’t believe the yield curve, there are still reasons to believe that a recession is around the corner. One is that consumer and business surveys give the same late-cycle signal as the Treasury market.
Marina Grushin: Does the recent steepening give you pause?
Scott Minerd: I wouldn’t draw conclusions based on a few trading days. Sure, the curve has steepened recently, but it’s been flattening for the last three years! As I said, longer-dated yields are getting closer to our expected terminal rate and there’s still more room for short-end yields to increase.
Marina Grushin: You’ve expressed concern about corporate debt. What are the risks?
Scott Minerd: The last recession featured overleveraged consumers and banks; the next one will feature overleveraged companies and non-bank investors that have taken on too much risk in the era of low rates and QE. As the Fed raises rates, it will choke off corporate free cash flow. Leverage among IG companies, which has already increased a lot in this cycle, will rise further when earnings roll over. This will help lead to a big wave of rating downgrades, thanks to the dramatic growth of the BBB segment of the corporate bond market. BBB-rated bonds now account for almost half of the Bloomberg Barclays Corporate IG index, yet many of their issuers have leverage ratios that were historically associated with BB securities. Passive bond funds have not only aided the buildup of these risks but may also exacerbate their impact when they eventually need to sell downgraded positions into an illiquid market. If the scale of downgrades is on par with prior cycles, the migration of “fallen angels” from BBB to BB could amount to about $1tn of debt, overwhelming the HY market. That will tighten financial conditions and hurt the economy.
Marina Grushin: Haven’t corporate borrowers mitigated these risks by locking in low rates at longer maturities?
Scott Minerd: Actually, a lot of corporate America appears more sensitive to changes in interest rates today, and that lot exists in the riskiest segment—issuers rated below investment-grade (IG). Floating-rate liabilities currently make up a larger piece of the high-yield (HY) corporate debt pie than at any time in the past; and if not this year, then next year, there will be more floating-rate bank loans than fixed-rate HY bonds outstanding. The companies that have locked in rates are typically IG, and won’t be the most vulnerable in a recession.
Marina Grushin: Does the growth of non-bank lending worry you?
Scott Minerd: It’s a risk we’re watching in the HY market. Fifteen years ago, around 80% of all syndicated loans remained on bank balance sheets through a “pro-rata” tranche that was a revolving credit line or an amortizing term loan; now, 70-80% of syndicated bank loans are outside of the banking system, meaning that the pro-rata tranche is much smaller in comparison to the institutional loan tranche that is distributed among non-bank lenders. We’ve also seen estimates that the private debt market has grown to around $400bn to $700bn in size—larger than the size of the bank loan market in 2007. That has made it harder to trace credit risk and maintain credit standards. Meanwhile, innovations like bank loan ETFs have moved credit risk into the hands of retail investors. That’s something we didn’t have to worry about in the last major crisis in corporate credit, in 2001/02. We’re in uncharted territory.
Marina Grushin: Putting this all together, how severe do you think the next recession will be?
Scott Minerd: The next recession may not be any more severe than average in part because policymakers are likely to act quickly knowing that they have limited policy options. But that lack of policy space worries me. In the US we’ll be entering the downturn with the largest peacetime budget deficit we’ve had outside of a recession, and the Fed is likely to be constrained by the zero bound once again, making this the recession when unconventional policies become conventional; we expect the Fed to cut rates to zero, employ aggressive forward guidance, and resurrect QE. Whether these tools will be as effective as the Fed claims they were in the last cycle remains to be seen. Keep in mind that achieving the equivalent of a 2% rate reduction—the difference between our 3.5% forecast for the terminal rate and the roughly 5.5pp of rate cuts in a typical easing cycle—would be worth several trillion dollars of QE. Put differently, we think the Fed will probably wish they had more powerful tools when the time comes to use them.
Outside of the US, the lack of policy space is even more concerning. Markets will force belt-tightening measures in Southern Europe, but the ECB will have minimal ability to cushion the downturn. Will the political systems in Italy, Spain, Portugal and Greece be able to deliver the fiscal tightening that markets will demand? If not, then we’ll have big problems. The BOJ will have limited options to fight a sharp appreciation of the yen, and China will be choking on bad debt after an epic debt binge over the last decade. These factors could make the next recession more severe than our models suggest.
Marina Grushin: What looks mispriced today?
Scott Minerd: Not surprisingly, we think credit spreads are too tight right now. For example, after adjusting for expected credit losses, HY bonds offer minimal value over Treasuries. While carry is reasonably attractive and trailing defaults are modest, a credit investor should not take for granted the ability to liquidate a position when the value proposition changes. The door is always smaller on the way out.
More broadly, turmoil in the credit markets will almost certainly spill over into the equity markets. In a scenario similar to 2001/02, we think HY spreads could widen by about 800bp or more, which corresponds to a roughly 40% decline in stocks— effectively a retracement to prior technical support levels, the S&P 500 highs of 2007 and 2000. While I don’t think the equity bull market is over yet, an eventual decline of that magnitude looks justifiable to me on a technical and a fundamental basis.
Marina Grushin: How soon should investors reduce risk?
Scott Minerd: Corporate credit spreads tend to start widening roughly one year before a recession begins, which would correspond to the first half of next year. But with spreads as tight as they are you aren’t giving up much by starting to reduce risk now. Besides, it takes time to turn a ship around.
Equities will probably peak a bit later in 2019, not least because the Nov-April period tends to be seasonally strong for stocks, especially after midterm elections. That will be the rally to sell. By the end of Q2 next year, I expect risk-off everywhere.
Marina Grushin: What should investors buy/sell today?
Scott Minerd: We’re underweight duration in our core fixed income funds to position for a rise in rates toward 3.5%. We expect the yield curve to continue flattening and recommend a barbell of high-quality, longer-duration bonds and floating-rate credit. We are upgrading credit quality and reducing our credit beta in anticipation of spread widening beginning next year.
Marina Grushin: What would have to happen for you to change your call for a recession in 2020?
Scott Minerd: We’d likely have to see faster supply-side growth, which would allow us to sustain this pace of economic growth without putting pressure on resource utilization. That would entail better productivity growth but also more rapid increases in labor supply. Despite some observers’ optimism that tax cuts will achieve the former, we don’t expect to see major productivity gains. As for the latter, Washington is unfortunately pursuing a self-defeating immigration policy. At a time when we should be welcoming new foreign workers who can fill the void left by retiring baby boomers, we’re instead looking for ways to restrict immigration.
Marina Grushin: What else are you looking out for?
Scott Minerd: Aside from our recession dashboard, we’ll be keeping a close eye on trade. An escalation of the US-China trade dispute looks nearly inevitable. Large majorities of voters across the US political spectrum describe China’s trade practices as unfair. We expect US politicians of both parties to exploit this angst. But the demands the US has made of China go to the very heart of the Communist Party’s growth model, so it’s hard to see Beijing capitulating. There will be a lot of collateral damage as this escalates. The policy response by the Chinese will be key; we are likely to see a material devaluation of the renminbi, which would put more downward pressure on other EM currencies. That could make it more difficult for EM borrowers to service their large stock of dollar-denominated debt, especially if it coincides with the onset of a recession.
The budget situation in Italy also bears watching. The government there is playing a dangerous game. As the Fed continues to tighten and the ECB winds down QE, Italy will find markets to be less forgiving—and once the US business cycle turns things will only become more difficult. Another crisis of confidence involving the euro appears inevitable.
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