Corporate Bonds Need the Economy to Remain Healthy in this Late Cycle Environment: Will it Happen?

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises national banks and federal savings associations and licenses, regulates, and supervises the federal branches and agencies of foreign banking organizations.

Twice a year they publish a semiannual risk assessment for the banking sector which begins with a review of the economic landscape. Large banks are nothing more than a leveraged play on the economy, so the OCC has a desire to get the call right.

So, what is the OCC call? Slower growth with an increased risk of inflation and bubbles.

The OCC, channeling the Blue-Chip forecasts, predicts the economy will slow back to its long-term potential rate of growth over the next two years. The OCC reviews the usual suspects: fading stimulus from recent tax cuts, the drag from a higher fed funds rate, a shortage of workers with corresponding wage inflation, the overhang from rapid growth in corporate debt, global trade and policy uncertainty, and slower growth abroad. Their forecast expects annual GDP growth to slow to 2.6 percent in 2019 and 1.9 percent in 2020, the latter of which is in line with the Congressional Budget Office (CBO) estimate of the long-term trend for U.S. economic growth.

A forecast for slower growth is consensus, but the OCC goes a little wide of consensus by suggesting that even with slower growth a positive output gap could lead to an increased risk for inflation and financial bubbles.

U.S. Output Gap as Percent of Potential GDP

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Just to review, a positive output gap is when the economy is operating above its long-term potential (see chart above). This normally happens at the end of an economic cycle and this expansion is ten years old! When there is a positive output gap there is an excess of demand and factories and workers operate above their most efficient capacity. This can lead to wage pressure and other forms of inflation.

During each of the recent economic expansions inflation accelerated as the output gap expanded. During the past two expansions, once the economy operated with a positive output gap, imbalances presented in tech-telecom and housing. We are now in the late-expansionary phase of this cycle, a period when inflation or unsustainable asset values have developed in the past. We are cautious as this cycle is different in many ways from previous cycles and history rarely repeats itself, but it does often rhyme.

Whether the OCC is right or not and how quickly the growth slowdown shows up really matters for risk asset prices, particularly for corporate bonds. While we have written at length this year on inflation and how the evolving nature of inflation will dictate Fed action and its impact on corporates, we shouldn’t forget about fundamentals. The Wall Street Journal reminded investors of this in an article over the weekend.

Much has been written about the build-up in corporate leverage, particularly for borrowers rated BBB. This is largely sustainable in a growing economy. But should the OCC’s forecast for slowing growth come to fruition, or a downturn comes quicker because of geopolitical actions, all bets are off. These risks, coupled with mediocre yield compensation for taking corporate risk, is why we are treading lightly with our corporate exposure at this time.

Source: OCC, WSJ