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The credit-market bears may well be vindicated if the US enters a recession in the next year, but it’s too early to go full-scale Armageddon with predictions about corporate bond spreads.
For all the economic headwinds, US corporations started the year from a position of extraordinary financial strength thanks to opportunistic refinancing in 2020 and 2021 and strong cash reserves accumulated during the pandemic. While clearly increasing from late 2021 levels, trailing 12-month high-yield default rates are still low for normal times, let alone recessions, and it could take several quarters for the defaults to start materializing in significant numbers.
In their baseline scenario, 1 Moody’s Investors Service analysts led by Sharon Ou forecast that default rates will continue ticking higher from here but remain below the 39-year historical average through at least August 2023. Meanwhile, a Bloomberg measure of bankruptcy activity hit the lowest level on record earlier in the year and has inched up only slightly. Credit spread blowouts tend to occur when large-scale bankruptcies are actually on the economy’s doorstep, not in anticipation of events that may be almost a year in the future.
In that sense, the corporate bond market finds itself in much the same no man’s land as the rest of the US economy. Predictions of a looming recession still have to be balanced against the near-record low unemployment rate and manageable debt service ratios.
And the US consumer, the engine of the American economy, still looks resilient, which should buttress growth and corporate earnings.
What’s less clear is whether those advantages will blunt the impact of a recession altogether; delay the downturn by a few quarters; or, on the flip side, prompt Federal Reserve Chair Jerome Powell to dig in his heels, pushing interest rates higher and higher to curb the worst inflation in 40 years. After all, monetary policy typically works by intentionally reining in demand, so any resilience may simply be met with a more powerful central bank response.
Clearly, the same facts can yield much different predictions, and many investors find themselves trying to strike a balance. The median projection in a Bloomberg survey of economists still shows even odds that the US will enter a recession in the next 12 months, and those probabilities have held constant since August, notwithstanding the sharp souring of market sentiment that’s taken place in interim.