Performing Credit Quarterly 4Q2023: The Goldilocks Trap

Summary

• The prevailing market narrative expects a U.S. economy that is neither too hot nor too cold, with the Federal Reserve cutting interest rates meaningfully without a recession.
• Investors are displaying Goldilocks thinking by pricing in a soft landing despite weakening long- and short-term market tailwinds.
• Fourth-quarter rallies included double-digit returns in equity indices, contracting yield spreads in high yield bond & leveraged loan markets, & falling Treasury yields.
• Ultra-low interest rates from 2008 to 2015 boosted the economy, asset appreciation, investment leverage, business financing, & default avoidance.
• Post-Global Financial Crisis monetary policy generated asset price inflation without significant wage or consumer price inflation due to limited funds reaching consumers.
• Globalization drove international trade growth from 39% of global GDP in 1990 to 56% in 2016, reducing U.S. consumer prices by 0.1 to 0.4 percentage points annually between 1997 & 2018.
• Global trade growth stalled in the mid-to-late 2010s, with the pandemic, rising U.S.-China tensions, populism, & geopolitical conflicts reducing prospects for further integration.
• Financial deregulation in the late 2010s included raising the asset threshold for strict bank regulations to $250 billion, weakening the Volcker rule, reducing liquidity requirements, & eliminating leveraged lending guidance.
• Bank failures in early 2023, such as Silicon Valley Bank, have prompted regulators to reassess capital adequacy & increased the likelihood of tighter capital buffers.
• 2023 consumption was supported by $2 trillion in excess pandemic savings, a low household savings rate of 4.0%, & increased borrowing despite credit card debt exceeding $1 trillion & rates near 25%.
• Three potential macroeconomic scenarios include a soft landing with gradual rate cuts, a hard landing triggered by shocks, or a soft-ish landing with mini default cycles & elevated rates.
• High yield bonds returned 9.2% from mid-October through year-end 2023, with an average yield-to-maturity near 8.0% & improved credit quality compared to a decade ago.
• High yield bonds trade at an average price of 92 cents on the dollar with an average duration of 3.3 years, offering convexity benefits as bonds mature.
• Reduced bank lending activity has created opportunities for alternative lenders in structured credit transactions involving music royalties, life sciences, equipment finance, trade factoring, aircraft finance, shipping finance, & rail cars.
• Existing U.S. home sales declined by roughly one-fifth in 2023 as mortgage rates spiked above 7.0%, while home prices remained near record highs due to low seller activity.
• Over 80% of homeowners hold 30-year mortgages below 5%, making them reluctant to sell & refinance at higher rates, though life events may eventually increase selling pressure.