Credit | Economics & Growth | Equities
In our last note, we outlined a core view on why the market should once again be moving towards pricing in a sub-trend growth scenario. Recent market price action and data are validating this view, but despite repricing, credit risk premia and implied volatility remain at very low levels. Now in this note, we discuss what could be inhibiting the conversion of slower growth into higher risk premium…
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
In our last note, we outlined a core view on why the market should once again be moving towards pricing in a sub-trend growth scenario. Recent market price action and data are validating this view, but despite repricing, credit risk premia and implied volatility remain at very low levels. Now in this note, we discuss what could be inhibiting the conversion of slower growth into higher risk premium.
Linear and Non-Linear Growth Risk
The situation may not be so unusual. The left-hand chart below shows that equity risk premium tends to price growth risks in a fairly linear fashion. This is intuitive: higher growth expectations increase the expected value of discounted future dividend payments (and vice versa).
The right-hand chart shows that this linear relationship fails to hold for credit risk premium (proxied by the US HY spread). This is because credit markets are primarily concerned about default risk, which is much higher in a recession but changes little when growth rates fluctuate around a high mean. The relationship between growth and credit risk is therefore non-linear – small fluctuations in growth don’t matter, but big ones do. You find a very similar relationship for implied volatility.
Figure 1: ISM Manufacturing Vs. ERP and HY Spreads
Source: Macro Hive
The market’s benign assessment of risk premia could mean one of three things:
i) Lower recession threshold. The market has correctly identified that despite growth slowing a lot, it has not slowed enough for non-linearities to kick in. This would mean there is a structurally lower ‘recession threshold’ level of growth where non-linearities kick in.
ii) Market distortion. If the ‘recession threshold’ is unchanged, something else is distorting the market’s pricing of risk premium.
iii) The market is wrong. The ‘threshold’ is unchanged and the risk premium backstops are not in place.
Lower Recession Threshold
The data shows this cycle has been abnormally steady. Recent growth outcomes in G7 economies imply that the volatility of growth has fallen, albeit around a lower mean. Has something fundamentally changed that makes a recession less likely?
Figure 2: Lower G7 Growth Volatility Around a Lower Mean
Source: Macro Hive
There are two things that would stand out to us. First, the DM financial cycle is in relatively early stages. Outside US corporates, the private sector has not meaningfully re-levered since the global financial crisis of 2008. Slower growth is unlikely to lead to widespread financial de-leveraging.
Second, the probability of central banks over-tightening in response to rising inflation has markedly declined. This is due to the structural weakening of the relationship between growth and inflation. The caveat is that low inflation (and the fall in r*) has meant that central bankers have reached this stage of the cycle with abnormally low amounts of policy ammunition. All else equal, this should increase the probability of left-hand growth outcomes as policy makers become unable to sufficiently stimulate growth when things turn south. It is also worth noting that lower inflation rates mean a lower threshold for unit labour costs to rise and eat into firms’ profit margins (something we are already seeing in the eurozone – see Chart 3 in our last note).
The market may be correct that negative feedback loops are less prevalent than they were heading into 2008. However, it seems remarkably complacent about policy makers’ limited ability to prevent left-hand growth outcomes. Something is likely distorting the market’s pricing of risk premium.
Market Distortion
Central banks have expanded their toolkit such that they can manipulate financial conditions better than ever before. Central banks are a lender of last resort, providing liquidity (traditionally to banks) in times of need. Asset purchase programs effectively allow this function to be performed much more directly in capital markets. Just like interest rates, financial conditions can now be controlled, and market participants know this.
But there are limits to the ability of central banks to manipulate market risk premium.
i) Liquidity and market size. Eventually there will be a threshold where large central bank holdings of securities negatively impact market functioning.
ii) Political constraints. QE is inherently political, particularly when it comes to risky assets. The ECB’s APP is one example. The BOJ has conducted ETF purchases, but it is hard to envisage a central bank owning 40% of the equity market and corresponding voting rights. It is equally difficult to imagine a central bank stepping in and saving a distressed non-financial corporate.
The biggest ‘non-linear’ threat to markets is policy makers breaching any one of these thresholds (liquidity, market size, political). This would have severe implications for asset prices that would feed back into the real economy. As growth slows further and forces more expansionary policy, the probability of testing these limits increases.
Which Market to Weaken?
Policy makers will do all they can to prevent a tightening of financial conditions. With the Fed still having some nominal space to cut interest rates, it would seem too early to bet against the central banks.
As a result, even if growth slows further, credit could continue to perform as risk free rates rally. However, investors should be cautious that various market measures of risk premium are probably distorted. The high yield space will look increasingly vulnerable as the Fed approaches zero.
Equity markets are least exposed to central bank distortion and are therefore the obvious place to expect further weakness. This still feeds back into the real economy via lower consumer confidence.
Figure 3: US Equity Valuations Vs. Consumer Confidence
Source: Macro Hive
Sam is a macro strategist focussed on bridging the gap between the macro and the market. He previously worked in Nomura’s asset allocation team, having held roles in FX strategy.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)