Reason to worry as Fed rate rise looms

As the Federal Reserve at long last appears ready to remove the zero interest rate honeypot, bears are growling that the US is moving into the final phase of its credit cycle. If they are right, investors should be paying attention.

There are five reasons to worry. First, corporate profits have turned down, and analysts have been cutting their forecasts of future profits. The fall so far has been only small, but it stands in stark contrast to the double-digit rises Wall Street usually hopes for.

Second, sales are not helping. US companies have seen revenue go nowhere amid the slow growth of the past few years. Data on manufacturing and trade collected by the Census Bureau show sales in those areas have been falling at a speed only seen since 1992 during recessions.

Third, credit markets are growing twitchy. The spread over government bonds demanded by junk bond investors has risen sharply, hurt in particular by unwanted oil debt. The price of “leveraged loans” to private equity has fallen too; this week the banks backing Carlyle’s purchase of data storage company Veritas shelved a $5.5bn offering of loans and junk after finding too little demand.

Fourth, America’s corporates (excluding the financial sector) have been exploiting cheap finance to a degree not seen since the heyday of the last credit bubble in 2007. Borrowing to buy back shares or engage in mega-mergers is back to pre-crisis levels, pushing up leverage — net debt compared to equity — back to where it stood in 2008.

Finally, default rates are picking up, with a tenth of US energy junk bond issues defaulting in the past year.

True, junk defaults hit very low levels of just 1.4 per cent last year, the lowest since 2007. But Standard & Poor’s predicts they will reach 3.3 per cent by next autumn, the highest since the recovery began.

Against this, bulls can point out that the Fed remains dovish even as it prepares to raise rates. When the Fed tightened in the mid-1980s and 1990s, junk bond defaults rose, but wider markets quickly recovered. In 2004, higher rates coincided with both a bull market and lower defaults. Mostly, bulls hope that higher rates will come in response to a stronger economy, so companies can grow out of their debt. Fingers crossed.

 FT