Performing Credit Quarterly 4Q2023: The Goldilocks Trap

The prevailing market narrative for the coming year demands a level of optimism that may be bordering on credulousness. The U.S. economy is expected to be neither too hot nor too cold, and the Federal Reserve is projected to begin cutting interest rates meaningfully without there being a recession or other crisis. In other words, everything is expected to be “just right.” While this could happen, we believe – to quote our co-chairman Howard Marks – that this all “smacks of Goldilocks thinking.” 

We acknowledge that there are several good reasons for this optimism, namely the rapid decline in U.S. inflation in 2023 and the country’s surprisingly resilient economy. However, we still think investors should proceed with caution, given how much Goldilocks thinking appears to be reflected in today’s asset prices. It’s notable that we saw rallies in both risk and duration in the fourth quarter: many equity indices reported double-digit returns, yield spreads in the high yield bond and leveraged loan markets contracted, and Treasury yields fell across the curve.¹ (See Figure 1.)

While we believe Goldilocks thinking is always dangerous, we think it’s especially so now, as investors are facing an environment in which multiple long- and short-term market tailwinds are weakening and, in certain instances, turning into headwinds that could create new risks and opportunities in the years ahead.

Figure 1: Fourth-Quarter Rally Reflects Rising Expectations for a Soft Landing

Source: Bloomberg; S&P 500 Index, Russell 2000 Index, ICE BofA US High Yield Constrained Index, Federal Reserve, as of December 31, 2023

Winds of Change

Over the last few decades, arguably no financial market tailwind was stronger than declining and ultra-low interest rates – as Howard Marks has written about extensively over the last year. As a reminder, not only did the Federal Reserve cut the fed funds rate to zero in late 2008 in response to the Global Financial Crisis, but it kept rates there for almost seven years.² (See Figure 2.) This provided a tremendous boost to the economy and markets. As Howard recently noted in his memo Easy Money:

Low interest rates made it:

• easy to run a business, with the stimulated economy growing unabated for more than a decade;

• easy for investors to enjoy asset appreciation;

• easy and cheap to lever investments;

• easy and cheap for businesses to obtain financing; and

• easy to avoid default and bankruptcy.

Figure 2: Interest Rates Remain Above the Ten-Year Average but Near the Long-Term Historical Average

Source: The Federal Reserve Bank of St. Louis

While ultra-loose monetary policy is typically expected to generate high inflation, this didn’t occur in the post-GFC period largely because little of the trillions that were plowed into the financial system made it into the pockets of consumers. The Fed’s quantitative easing and zero interest rate policies helped to spur substantial asset price inflation, but they didn’t put much upward pressure on wages or consumer prices. (The inflationary picture was obviously quite different during the recent crisis because so much of the U.S. government’s roughly $5 trillion in stimulus spending was in the form of direct cash payments to individuals or other subsidies that helped households and small businesses.) 

With inflation often running below 2% in the period between 2008-20, the Fed had little incentive to tighten monetary policy meaningfully, especially given that the market reacted negatively almost any time the Fed appeared to be turning even slightly hawkish. Thus, expectations rose that interest rates would remain low perpetually, which left many borrowers vulnerable once this long-term trend reversed. As we stated in Performing Credit Quarterly 3Q2023, “many companies – especially those with outstanding leveraged loans or private debt – borrowed too much … creating capital structures that have become unsustainable now that interest rates have risen by more than 500 basis points.”

Importantly, low interest rates are closely intertwined with many other tailwinds³ that helped support economic growth and asset prices in recent decades. Let’s consider two such trends. 

(1)  Globalization: Increased international trade and global integration helped to spur economic activity from the 1990s through the mid-2010s. Total international trade rose from roughly 39% of global GDP in 1990 to 56% in 2016,⁴ propelled largely by China’s booming economy, which grew by an average annual rate of roughly 9% from 1979 to 2019.⁵ Importantly, this boost in trade is believed to have reduced U.S. consumer prices by 0.1 to 0.4 percentage points annually between 1997 and 2018,⁶ one of multiple factors that enabled the Fed to keep interest rates low for decades.

While experts debate how much globalization is weakening, there’s substantial evidence that its dramatic growth stalled in the mid- to late 2010s as anti-trade rhetoric increased. The Covid-19 pandemic then upended international trade and caused companies to reconsider their long supply chains and begin exploring nearshoring opportunities. Meanwhile, tensions between China and the U.S. have continued to rise, populism and economic protectionism have intensified around the globe, and a spate of geopolitical conflicts have reduced the likelihood of greater global economic integration in the coming decade.

(2)  Financial deregulation: While the U.S. government tightened financial regulations after the GFC, it began to loosen restrictions in the years leading up to the pandemic – a shift that was enabled, in part, by the low default rates engendered by ultra-loose monetary policy. In 2018, then-President Donald Trump signed a bill into law that eased financial restrictions on regional banks; this included increasing the level of assets banks needed to hold to be subject to the strictest regulatory requirements to $250 billion from $50 billion.⁷ Additionally, the Fed began to water down certain regulations beginning in the late 2010s. For example, it weakened the “Volcker rule” (which restricted banks’ proprietary trading activities), reduced several liquidity requirements, and essentially eliminated the leveraged lending guidance created in 2013.⁸ These actions likely enabled many banks to expand lending, which, in turn, boosted economic activity.

However, bank failures in early 2023 – most notably the collapse of Silicon Valley Bank – have caused regulators to rethink how they should be assessing capital adequacy. If default rates rise and stress on banks’ balance sheets continues to grow – a distinct possibility given that banks are still grappling with legacy portfolio issues related to leveraged buyout debt and commercial real estate loans – then the calls for regulators to increase buffers in the financial system will only grow louder. Considering all this, it’s reasonable to assume that banks will have less ability to provide capital moving forward – just as more companies are seeking to refinance massive debt burdens taken on in the easy money era.

On top of these longer-term changes, we also expect to see the weakening or reversal of many of the shorter-term tailwinds that kept consumption, and thus economic growth, surprisingly robust last year. Consumption in 2023 was much stronger than anticipated largely because of three key trends:

1. The estimated $2 trillion in excess savings that households amassed during the pandemic lasted longer than many models had predicted.⁹

2. Households saved a low percentage of their incomes. The savings rate fell to around 4.0% at year-end after hitting double-digit rates in 2020 and 2021.¹⁰

3. Consumers were increasingly willing to borrow to deal with the strains of rising prices. Credit card debt eclipsed $1 trillion in 2023, even as the average interest rate on new credit cards climbed to almost 25%.¹¹

So what can we expect moving forward? While the unemployment rate remains low and real wage growth has turned positive, consumers now have a reduced stock of savings to draw from to handle higher prices, and it’s unclear how much more they’ll be willing and able to borrow. (See Figure 3.) In short, we might finally see the seemingly indefatigable U.S. consumer slow down.

Figure 3: The Stock of Excess Savings and the Flow of New Savings Have Fallen

Source: Federal Reserve Bank of San Francisco, Federal Reserve Bank of St. Louis

Sticking the Landing

Against this backdrop, we think one of three near-term macroeconomic scenarios is likely:

1. Soft (or no) landing: In the most benign scenario, the labor market would remain strong, and the economy would limp through the coming years without falling into a recession. If unemployment were to begin creeping upward, the Fed would have plenty of room to cut rates to stimulate growth. While floating-rate borrowers and fixed-rate borrowers with near-term maturities would obviously benefit if interest rates were to decline gradually and the economy were to avoid recession, many companies with high debt burdens are still likely to struggle unless interest rates fall back near zero.

2. Hard landing: If there is an unexpected spike in defaults, a rapid decline in home prices, a sudden change in the employment picture, an unanticipated geopolitical event, or some other shock that’s completely off the radar, then the U.S. economy could enter into a serious recession. While these types of extreme events would likely elicit a dramatic response by the Fed – as we saw in both the GFC and the pandemic – officials may not have the ability or the inclination to both cut interest rates to zero and keep them there for a considerable period of time, given the altered inflationary environment and the risks created by the last decade-plus of ultra-loose monetary policy.

3. Soft-ish landing: Even if the economy doesn’t experience a true hard landing, it could skid on the tarmac for a while. As the impacts of elevated interest rates and multiple years of rapid inflation work through the U.S. economy, we could see mini default cycles in various sectors and asset classes. The most immediately vulnerable, as we noted previously, are (a) floating-rate borrowers, especially those in sectors with particularly high leverage levels, and (b) commercial real estate investors, which face almost $3.0 billion in near-term maturities in the U.S.¹² Risk may then migrate to fixed-rate borrowers with maturities in 2026-28, as these companies may struggle to fill funding gaps if interest rates stay above the ten-year average. Thus, negative forces may weigh on the economy for years – not to the point of creating mass hysteria but also not to the point of provoking massive interest rate cuts.

What Could Go Wrong?

At Oaktree, we continuously ask ourselves “what could go wrong?” We believe that seeking to construct portfolios with sufficient shock absorbers makes managers less likely to find themselves scrambling to rescue existing assets and more likely to be in a position to take advantage of bargains. In the current environment, we think investing prudently means avoiding falling into the trap of assuming that today’s Goldilocks narrative will play out exactly as written. As Howard recently noted:

I’ve seen Goldilocks thinking in play a few times over the course of my career, and it rarely holds for long. Something usually fails to operate as hoped, and the economy moves away from perfection.  One important effect of Goldilocks thinking is that it creates high expectations among investors and thus room for potential disappointment (and losses).

Credit Markets: Key Trends, Risks, and Opportunities to Monitor in 2024

(1) The case for high yield bonds remains very strong

The U.S. high yield bond market experienced a robust rally at the end of 2023, returning 9.2% from mid-October through year-end, due to declining Treasury yields, reduced recession fears, large retail fund inflows, and limited new issuance.¹³ However, the asset class remains attractive on a relative basis due to several important factors. 

High expected return: The average yield-to-maturity in the asset class is near 8.0% – which is well above the ten-year average – and compelling compared to the roughly 5.0% offered in the investment grade bond market.¹⁴

High quality: Around half of the asset class is rated BB (the credit rating tier just below investment grade) and only 11% is rated CCC (the lowest tier), compared to 45% and 17%, respectively, a decade ago.¹⁵ For context, only one-quarter of the U.S. leveraged loan market is currently rated BB.¹⁶ This quality advantage partly reflects the increase in the average size of high yield bond issuers in the last decade, as smaller borrowers have increasingly migrated to the leveraged loan and private credit markets. Additionally, leverage ratios in the asset class are fairly healthy compared to the pre-pandemic and long-term averages. (See PCQ 3Q2023 for more details.)

High average convexity: U.S. high yield bonds still trade at an average price of 92 cents on the dollar, and their average duration is 3.3 years, roughly half the average duration of investment grade bonds.¹⁷ Thus, high yield bonds should benefit meaningfully from the pull to par in the coming years as bonds mature. Additionally, all fixed rate assets, including high yield bonds, should be better positioned than they were in recent years now that the likelihood of near-term interest rate increases has fallen sharply.

(2) Opportunities continue to emerge as a result of weakness in the banking system

The areas where banks were most active in the years before 2022 were typically those where they were the incumbent lenders. However, in recent years, banks have had to contend with multiple challenges, including enormous sums of hung bridge debt, weak commercial real estate books, and uncertainty surrounding potential regulatory changes. Thus, banks have often reduced their lending activities, including in the areas they previously dominated. This has created the potential for alternative lenders to gain share in new markets that are uncorrelated or only modestly correlated with traditional corporate lending deals. 

For example, private credit investors are increasingly finding attractive opportunities in a wide variety of structured credit transactions, including those involving music royalties, life sciences royalties, equipment finance, trade factoring, lender finance, aircraft finance, shipping finance, and rail cars – just to name a few. Loans through these intermediaries are often generating returns on par with – or even a little above – those seen in corporate direct lending, and, importantly, they typically feature a broad, diversified, global asset base.

(3) Trends in residential real estate prices should be monitored closely

The dramatic increase in mortgage rates over the last two years has created complex dynamics in the residential real estate market, creating both risk and opportunity. In 2023, existing U.S. home sales declined by roughly one-fifth year-over-year.¹⁸ That’s largely because mortgage rates spiked above 7.0%, dampening appetite from buyers.

However, home prices have remained near record-high levels even though willing buyers have become more scarce. Why?  Because willing sellers have also become harder to find. Homeowners with 30-year mortgages below 5% – over 80% of the market – have been loath to sell, as that can mean taking on a new mortgage at a rate that is far higher than what they’re currently paying.¹⁹

But will this situation last? A significant percentage of home sales are typically driven by life events (e.g., divorce, job changes, etc.). Given that these events will occur no matter what mortgage rates are, we shouldn’t expect selling pressure to remain suppressed indefinitely. If we do see a spike in this pressure, you could potentially see a meaningful decline in home prices, due to the current market dynamics. And, importantly, U.S. homeowners typically measure their personal wealth based on the value of their homes and their ability to access that value through lines of credit. Thus, if vulnerabilities emerge in the residential real estate market, it could have significant knock-on effects on consumer spending and the economy overall. However, it could also create attractive buying opportunities for prudent real estate investors with capital to deploy.