Has the credit versus equities recession playbook changed?

Never in history has a US recession been more anticipated than in this business cycle. While the Federal Reserve (Fed) is pulling out all the stops to cool inflation, the US economy has surpassed expectations and performed resiliently. Despite this, we remain in the camp of those expecting a US recession to occur this year.

So, if we are correct in our analysis, it begs the question what will the consequences of recession be for the main risk assets of corporate bonds, or credit, and equities?

During past recessions, credit has tended to sell-off first and recover earlier than equities. This has encouraged investors to reintroduce risk into their portfolios by increasing their allocation to credit before turning to equities. But this time around, the starting position of corporate balance sheets is stronger compared to previous cycles.

Does this mean the recession playbook between credit and equities is different?

Risk assets aren’t discounting a recession

Credit spreads are widely used to track economic activity as they are often seen as a leading indicator of recessions. Over the last 30 years, they have had a slightly better track record at signalling US recessions than the equity risk premium (measured by S&P 500 returns in excess of US 10-Treasury returns).

As economic growth slows, investors become more concerned about the risk of corporate defaults. To take on this extra risk, they demand higher yields on corporate bonds, which causes credit spreads to widen versus government bonds. The implications of default are particularly relevant to corporate bonds, which are generally less liquid than equities and harder to offload during periods of market turmoil.

At present, both the equity and credit markets are signalling a low probability of a recession, based on high-yield bond spreads or the US equity risk premium (see chart 1), or total returns for these markets (chart 2).

This is an improvement on last year when the sell-off in equity and credit markets meant that recession probabilities surged to levels indicative of a recession. Certainly, the performance fortunes of the equity and credit markets last year were influenced by their sector exposures. Specifically, the slump in the S&P 500 was driven by the significant sell-off in growth and technology stocks, which were hit by the aggressive tightening of policy by the Fed. This is because these stocks are expected to generate a large proportion of their earnings in the future, so future cash flows are being discounted at a higher rate.

That said, recession probabilities based on credit spreads and the equity risk premium were mostly likely held down by the strong sell-off in government bonds last year. So, in relative terms, equities and credit would have fared worse and the fundamental picture behind the credit market was not so much a contributing factor to the resilience of corporate bond spreads. But this does not mean that the state of corporate balance sheet is less relevant in understanding whether the recession playbook between credit and equities could be different this time.

Credit tends to move before equities during recessions

Historically, equities have tended to be late to the sell-off compared to credit in the run-up to recessions. Chart 3 illustrates that in the US, the high-yield bond spreads began to meaningfully widen in the second half of 2007, primarily due to concerns over the corporate impact of the subprime mortgage crisis. But the S&P 500 did not experience significant declines until the start of the Great Recession. Similarly, high-yield credit spreads began to widen at the start of the millennium while the Dot-com bubble did not burst until later in the year (chart 4).

As credit markets tend to sell-off before equities in the run up to a recession, they also tend to bottom out and recover earlier (table 1). It is worth noting that table 1 focuses on investment grade (IG) corporate bonds, as they have a longer history compared to high-yield bonds. On average, IG corporate bonds have hit their lowest point six months before the end of recessions, compared to three months for equities.

One possible explanation for why equities tend to bottom out later than corporate bonds is that credit markets are generally more sensitive to shifts in the economic cycle and the potential for corporate defaults. Credit is also typically less liquid than equity markets, which may mean investors are more likely to unwind their credit positions earlier than their equity investments.

But on closer examination, the recovery in government bonds has played an important role in the earlier improvement of credit performance compared to equities during recessions. This is because interest rates have typically been cut during recessions, which supports duration assets such as credit. It also worth noting that investors have incentives to close out their underweights in credit positions given that they lose carry and roll¹ for being short credit for long periods.

When examining the excess return of IG credit over government bonds, there is barely any difference in the average timing between the S&P 500 and corporate bonds in reaching the bottom before the end of recessions (table 1). At the same time, the duration exposure of credit has also helped corporate bonds to outperform equities during past recessions.

Corporate balance sheets are in a strong position

Despite the recent banking turmoil,  tighter financial conditions and the deterioration in the growth picture this year, credit spreads have barely widened. This could be attributed to a couple of factors. Firstly, there is no impending maturity wall as a relatively small proportion of corporate bonds are due to be repaid or refinanced in the next couple of years.

Secondly, the balance sheets of companies are coming from a strong position with healthy cash to asset and debt ratios. While the ability of companies to service their debt obligations, known as the interest coverage ratio, has fallen recently, corporates still have plenty of room to cover their interest payments (chart 5). In particular, the interest coverage ratio of nonfinancial companies is close to record highs.

But the aggressive increase of interest rates by the Fed has led to cracks appearing. Interest expense growth has significantly risen such that it is now at the highest level since the GFC (chart 6). This is expected to put pressure on the interest coverage of companies, as higher interest payments are likely to coincide with the contraction in earnings from a recession. We are already seeing earnings growth and corporate margins ease from peak levels.

So, as the US economy enters a recession later this year, there is a possibility of spread widening prompted by a deterioration in fundamentals. But the strong starting point for corporate bonds may result in a less severe impact on the market compared to previous cycles. Whether credit markets will bottom and recover before equities during the recession remains to be seen but is likely to be dependent on the path of interest rates.

It is all about interest rates

Table 2 shows periods where credit and equities hit their low points closer to each other or when equities bottomed out first, such as in the 1970s and 1980s, generally coincided with the Fed starting to cut rates nearer to the end of recessions. In other words, the sooner the central bank eases policy, the earlier credit was able to bottom and recover primarily driven by their duration exposure. Interestingly, both the recessions in the 1970s and 1980 happened during periods of high inflation, which is why interest rates were not cut sooner compared to other recessions.

Conclusion

Every recession is different, and it is hard to time recessions, but we expect an US recession to occur in the fourth quarter of this year and the first quarter of next year. Besides being a relatively short recession, the contraction in economic growth is assumed to be modest compared to past recessions. With the Fed expected to cut interest rates in December this year, a few months before the end of the recession, it may mean that there is less of a timing difference in the bottoming and recovery of both credit and equity markets.

At the same time, the strong position of corporate balance sheets may mean that spreads don’t widen as much, which could also mean that they will be relatively less attractive when markets re-rate. Overall, the recession playbook between credit and equities may be different this time around. Investors may not necessarily prioritise credit as a means to add risk in their portfolio, as has been the case in past cycles.

¹The carry and roll of a bond is the opportunity cost for not owning duration assets. Firstly, the investor holding a short position needs to pay interest on the borrowed bond to it owner. This is known as the ‘cost of carry’. Secondly, shorting a credit bond can result in losses due to the ‘roll’. As the bond approaches its maturity date, it needs to be replaced with a new bond to maintain the short position. If the new bond has a higher yield than the old bond, the investor who is short needs to pay the difference in yield to the bond’s owner.