Investing Advice: Navigating a Market in Transition
By: Steve Smith
Where can we look to see where we are in the process? We are watching rising subprime auto loan defaults, rising delinquencies for credit cards held at smaller banks, and the spread between investment grade and high yield corporate bonds. We are currently sitting at all-time debt-to-GDP ratio highs and the share of investment-grade bonds that are BBB-rated is up to nearly 50%. This means there is a growing risk associated with a wave of credit downgrades once the economy slows, which would force selling of bonds that are no longer investment grade.
We are watching interest rates rising during a year when $1.5 trillion of investment grade credit is coming due and an additional $430 billion of high yield credit, much of the proceeds of which were used to fund share buybacks, leaving balance sheets more highly leveraged.
We are seeing economic expectations being reset. At the beginning of February, the Atlanta Fed GDPNow was 5.4% but has now fallen to 1.9%. Looking out to the rest of 2018, the potential impact of the now rising potential for real trade wars is a headwind to many sectors that will at the very least increase input costs, reducing corporate profit margins. This coming at a time when we are hearing nonstop about the tight labor market, which is also expected to put upward pressure on labor costs, which will also reduce corporate profit margins.
For investing advice, the bottom line is that in 2017, the market was very focused on hearing only what it wanted to hear. To be fair, the economic data coming in was mostly positive, as were the actions coming out of Washington D.C. But as we are seeing, 2018 is not 2017. We are witnessing a market in transition. That synchronized global expansion is rolling over. The VIX, the volatility index, this year is on average 50% higher than it was last year. The last time this happened was 2008.
Looking at the past, in periods where the VIX is low and declining, the bull market is intact. When it rises and sets new and higher ranges, it means we are in transition, and so we are. As I said above, the easy money liquidity punchbowl is being drained. All that liquidity that had been pushing asset prices higher is being sucked out of the system and in its wake, we have record high levels of debt across a broad range of the U.S. economy and the globe. This is the time for quality balance sheets, better earnings visibility and an active eye on the evolving data.
Related: This Chart Shows a Market in Trouble – Here’s What You Should Do.
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