Director of Real-Time Economics
Ryan Sweet is director of real-time economics at Moody's Analytics. He is also editor-in-chief of Economy.com, to which he regularly contributes, and a member of the US macroeconomics team in West Chester, PA. He is among the most accurate high-frequency forecasters of the US economy, according to MarketWatch. He is also an adjunct professor in the Economics and Finance Department at West Chester University of Pennsylvania. He has a master's degree in economics from the University of Delaware and a bachelor's degree in economics from Washington College.
In 2018's final quarter, the 22 downgrades of U.S. investment-grade companies included nine that were at least partly ascribed to mergers, acquisitions and divestitures and three that were linked to equity buybacks. Only half, or 11, of fourth-quarter 2018's U.S. investment-grade downgrades were primarily driven by worsened operating or market fundamentals.
The outstanding high-yield corporate bonds of U.S.-domiciled issuers fell from a year earlier for an eighth consecutive quarter in 2018's final three months. Fourth-quarter 2018's 4.6% year-over-year drop lowered the outstandings of U.S. corporate high-yield bonds to $1.221 trillion, which was 9.1% under fourth-quarter 2016's current zenith of $1.344 trillion.
The world is now incapable of shouldering a 10-year Treasury yield above 3%. A remedial decline by the U.S.' benchmark interest rates will be critical to rejuvenating global business activity and stabilizing financial markets. Otherwise, the corporate earnings outlook might deteriorate by enough to sink the market value of U.S. common stock by another 20% and swell the now 552 basis point high yield bond spread to 800 bp.
Given the Fed's willingness to continue its two-pronged firming of monetary policy amid slower economic growth and below-target inflation, the still benign outlook for corporate credit will be menaced by above-average risk. In view of above-average international and domestic political risk, as well as the uncertainties stemming from trade frictions between China and the U.S., the last thing 2019's outlook needs is elevated interest-rate risk.
The investment-grade bond market appears more anxious about the future than the high-yield bond market. A now well above-trend Baa industrial company bond yield spread warns of a wider high-yield bond spread. To the contrary, a trend-like high-yield spread favors a thinner Baa spread. In all likelihood, if the still positive outlook for profits holds, the high-yield bond spread will prove to be more prescient than the now swollen Baa spread.
Both the sell-off of equities and the very limited and slight inversion of the Treasury yield curve at the three- and five-year maturities hint of a possible pause for the latest series of Fed rate hikes. Since September 26's last hiking of fed funds to 2.125%, the 10-year Treasury yield has dropped from 3.05% to a recent 2.87%, and the five-year Treasury yield has sunk from 2.95% to 2.74%.
Profitability will have the final say regarding the future direction of the corporate credit cycle. Each of the five deep and extended contractions by profits since 1982 helped to lift the high-yield default rate well above 5%. Moreover, three of the five pronounced downturns by profits overlapped each of the recessions since 1982. For now, the outlook for corporate earnings benefits from the surprising containment of employee compensation notwithstanding the lowest unemployment rate in 49 years.
Greater uncertainty surrounding the sustainability of corporate earnings growth has adversely affected the performance of medium- and lower-grade corporate bonds. If fears over the adequacy of future corporate earnings persist, the upside for benchmark U.S. interest rates is probably well under consensus expectations.
Gridlock is here. Because of the constraints placed on fiscal policy by a Democratic House and a Republican Senate, the Federal Reserve's role at assuring an adequate rate of economic growth has been magnified. Though currently not a pressing issue, a widely anticipated deceleration of corporate revenues and profits may eventually influence Fed policy. Such slowdowns increase the risk of widespread cutbacks in business outlays on capital goods and staff. A severe enough retrenchment in business spending would quickly end the current episode of monetary firming. Both equities and corporate bonds can transcend the slower growth of corporate earnings. However, if an unbending climb by benchmark interest rates amid continually slower profits growth triggers expectations of a prolonged shrinkage of earnings, share prices will sink and corporate credit spreads will swell.
Recent outsized advances by equity prices probably owe something to either actual or anticipated buybacks of common stock. Both the relative steadiness of corporate credit quality and ample amounts of corporate cash now improve the outlook for equity buybacks. In the Financial Accounts of the United States, the Federal Reserve supplies an estimate of net equity buybacks, where the estimate applies to net buybacks of both common and preferred equity. Because of an often heavy use of preferred stock by financial companies, net buybacks of nonfinancial-corporate equity are the preferred measure when analyzing the behavior of net equity buybacks over time. For example, the $55 billion of total net equity buybacks for the year-ended June 2018 consisted of $485 billion of net stock buybacks by U.S. nonfinancial companies and $281 billion of net equity issuance by U.S. financial institutions.