U.S. Leading Economic Indicators Increase

The Conference Board’s Composite Index of Leading Economic Indicators increased 0.4% (6.4% y/y) during August after a 0.7% July gain, revised from 0.6%.

Movement amongst the components of the index was mixed last month. Improvement was led by a higher ISM new orders index, the leading credit index, a steeper interest rate spread between 10-Year Treasuries & Fed funds, stronger stock prices and improved consumer expectations for business/economic conditions. Also, initial claims for unemployment insurance fell and orders for consumer goods & materials improved. Fewer new orders for nondefense capital goods excluding aircraft and the length of the average workweek for production workers had negative effects.

Three-month growth in the leading index strengthened to 6.7% (AR), but remained below its 10.3% December 2017 peak rate of change.

The Index of Coincident Economic Indicators increased a steady 0.2% (2.5% y/y) in August. Three-month growth in the coincident index of 2.7% (AR) was improved from 1.6% growth early in the year.

The Index of Lagging Economic Indicators increased 0.2% (2.3% y/y) last month after an unrevised 0.2% July decline. Three-month growth in the lagging index fell sharply to 0.8%, its weakest growth since November and down from 4.7% in June.

The ratio of coincident-to-lagging indicators is often considered to be a leading indicator of economic activity. As economic slack diminishes relative to current performance, the ratio will rise. It held steady at a slightly improved 99.0 last month.

U.S. Existing Home Sales Hold Steady

The National Association of Realtors reported that sales of existing homes during August were unchanged at 5.340 million (SAAR, -1.5%). July’s figure was unrevised. Sales remained at the lowest level since February 2016, down 6.6% versus the November peak. Expectations had been for 5.37 million sales in the Action Economics Forecast Survey.

The median price of all existing homes sold declined 1.7% last month (+4.6% y/y) to $264,800, down 3.3% from the June record of $273,800. The average sales price fell 1.4% for a second month (+3.0% y/y) to $303,200.

Sales of existing single-family homes held steady last month (-1.0% y/y) at 4.750 million units. Sales of co-ops & condos also were unchanged (-4.8% y/y) at 590,000.

The number of homes on the market increased 2.7% y/y. The supply of homes on the market was unchanged at 4.3 months, up from the record low of 3.2 months in December.

Trade Fears Dial Down Optimism Among CFOs

Eighty-nine percent of CFOs said current economic conditions in North America are good during the third quarter. That’s down from 94% during the second quarter, according to CFO Signals, a quarterly outlook survey conducted by Deloitte LLP. Forty-two percent said conditions would improve next year, the lowest in two years, and down from 52% during the second quarter.

Deloitte’s findings, released Thursday, came from a small sample: The firm surveyed 132 finance chiefs in the U.S., Canada and Mexico, 89% of which were at companies with revenues of more than $1 billion. But the results echoed larger surveys conducted by Duke University and the American Institute of CPAs.

North American respondents to the Duke University/CFO Global Business Outlook survey said the optimism index declined to 70 during the third quarter from an all-time high of 71 last quarter. Duke University’s Fuqua School of Business and CFO magazine conducted the survey, which polled more than 800 global CFOs, including 260 from North America.

Meanwhile, 69% of U.S. finance executives surveyed by the AICPA said they were optimistic about the economy over the next 12 months, the trade association said this month. That’s down 10 percentage points from a record high of 79% seen in the first quarter of 2018, and a pull back of 5 points from the previous quarter. The trade association surveyed 1,242 certified public accountants in leadership positions at U.S. organizations.

Trade policy, a tight labor market and tariffs dominated the external risks CFOs outlined as their top concerns, according to the surveys.

Companies that said they were negatively impacted by the trade friction and tariffs plan to reduce their capital spending by 6%, compared to a 5.7% increase in planned capital spending across all firms, according to the Duke survey. (…)

FLASH PMIs

IHS Markit Flash U.S. PMI: Boom…

September data indicated another slowdown in U.S. private sector output growth. At 53.4, down from 54.7 in August, the seasonally adjusted IHS Markit Flash U.S. Composite PMI Output Index pointed to the weakest upturn in business activity since April 2017. The overall moderation in output growth was driven by the service economy, which more than offset an accelerated rise in manufacturing production.

Anecdotal evidence suggested that some of the slowdown in overall output growth reflected company shutdowns on the east coast ahead of hurricane Florence. These disruptions contributed to a solid increase in unfinished business during September. Backlogs of work were accumulated at the fastest pace for three months.

Latest data revealed that new order books strengthened since August. The overall rate of new business growth was the fastest since June, which survey respondents attributed to resilient demand conditions across the wider U.S. economy.

Payroll numbers increased at a robust and quicker pace in September. The latest rise in employment was the strongest since May 2015, led by a rebound in job creation at service providers.

Average prices charged by private sector firms increased at the sharpest rate seen in the nine-year survey history. Service providers signalled a particularly steep rise in output charges in September, which they commonly attributed to the pass through of higher labor costs and increased prices for inputs sourced from abroad.

Manufacturers widely noted that trade tariffs had led to higher prices for metals and encouraged the forward purchasing of materials. Some firms commented that higher demand and resilient order books had helped them to offset squeezed margins by pushing up output charges.

Future expectations meanwhile fell to the lowest so far in 2018, and the second-lowest in over two years, as optimism deteriorated in both the manufacturing and service sectors.

IHS Markit U.S. Services PMI™

The seasonally adjusted IHS Markit Flash U.S. Services PMI™ Business Activity Index dropped to 52.9 in September, from 54.8 in August, to signal the weakest expansion of service sector output since March 2017. However, a renewed rise in backlogs of work and stronger new business growth provided signs of resilient underlying demand during September.

Efforts to boost operating capacity underpinned a robust and accelerated upturn in employment. The rate of job creation in the service economy was the fastest since May 2015.

Expectations for activity growth over the year ahead softened in September. The degree of positive sentiment was the lowest since December 2017. Some firms commented on intense cost pressures. This was also highlighted by a strong rise in input prices in September, while average prices charged by service providers increased at the fastest pace since the survey began in October 2009.

IHS Markit U.S. Manufacturing PMI™

The seasonally adjusted IHS Markit Flash U.S. Manufacturing Purchasing Managers’ Index™ (PMI™) pointed to a robust improvement in business conditions across the manufacturing sector during September. At 55.6, up from 54.7 in August, the headline index was the highest since May.

Stronger rates of output and new order growth were the main factors boosting the PMI in September. Stock building also had a positive contribution to the headline index, with pre-production inventories rising at the fastest pace since December 2016.

Input buying increased at the strongest rate for four years in September. A number of manufacturers commented on forward purchasing in response to global trade tensions and longer delivery times from domestic suppliers.

There were signs that manufacturers have become more cautious about the year-ahead growth outlook, with business sentiment moderating to its lowest since March 2017. Moreover, staffing numbers were expanded at the weakest pace for 13 months in September.

Chris Williamson, Chief Business Economist at IHS Markit:

(…) business activity remained encouragingly resilient during the month, commensurate with third quarter GDP growing at an annualised rate approaching 3%.

Growth may well pick up again as we move into the fourth quarter. With new orders growth accelerating and backlogs of work rising due to weather-related disruptions, the survey data suggest underlying demand remains robust and that there’s an accumulation of work that will roll over into stronger economic growth in coming months.

Most encouraging was an upturn in hiring. The survey’s employment gauge rose to a level indicative of non-farm payroll growth topping 200,000 in September.

On the downside, prices charged spiked higher again during the month, rising at the steepest rate seen for at least nine years, as supply shortages and rising costs, often linked to tariffs, fed through to selling prices.

The escalation of trade wars, and the accompanying rise in prices, contributed to a darkening of the outlook, with business expectations for the year ahead dropping sharply during the month. While business activity may rebound after the storms, the drop in optimism suggests the longer term outlook has deteriorated, at least in the sense that growth may have peaked.

Stagnant exports subdue Eurozone growth in September

Eurozone business activity grew in September at the second-weakest rate since late-2016, according to preliminary PMI survey data, as manufacturing growth was subdued by export orders stagnating for the first time in over five years.

The IHS Markit Eurozone PMI fell from 54.5 in August to 54.2 in September, according to the flash reading, which is based on around 85% of usual replies. Although still well above the 50.0 no change level, the latest reading was the lowest since November 2016 with the exception of last May.

New order inflows were the joint-weakest since October 2016 and backlogs of uncompleted orders rose at the slowest rate since September 2016. Employment growth proved more resilient, easing slightly from August but remaining close to 18-year highs.

The slowdown was driven by weaker growth in the manufacturing sector, where production increased at the slowest rate since May 2016. New orders received by factories showed the joint-weakest rise since February 2015 as new export orders failed to grow for the first time since June 2013.

Backlogs of work fell in factories for the first time since April 2015 as a result of the weakened inflow of work, contributing to an increased reluctance to hire additional staff. Factory payroll numbers rose at the slowest rate for just over one-and-a-half years.

Service sector output growth meanwhile picked up momentum for a second successive month to reach a three-month high, albeit remaining well below rates seen earlier in the year, and job creation continued to run at the highest since October 2007.

New inflows of business slowed, however, and backlogs of work showed the second-weakest rise in over a year, hinting at slower service sector activity and employment growth in coming months.

Input cost inflation meanwhile remained elevated, picking up slightly to the third-highest for over seven years. Average selling prices rose at an identical pace to the solid gain recorded in August, though likewise remained high by standards of the past seven years.

While input costs rose at the fastest rate for over seven years in the service sector, in part reflecting higher wage and energy costs, manufacturing costs rose at the joint-slowest rate for just over a year.

Looking ahead, business optimism about future activity levels revived slightly from August but was still the second-gloomiest seen over the past two years, dropping to the lowest for nearly four years in manufacturing but ticking up from August’s 21-month low in the service sector.

Across the region, growth slowed in Germany and France but both continued to outperform the rest of the eurozone as a whole, where the pace of expansion held close to two-year lows. Growth of both business activity and new orders lost some momentum in Germany, meaning jobs growth likewise cooled slightly, though remained close to seven-year highs. The third quarter as a whole has nevertheless seen stronger output growth than the second quarter. The latest expansion was fuelled by service sector growth hitting an eight-month high, in turn buoyed by the biggest inflow of new work since June 2011 and accompanied by the largest jump in services employment since October 2007.

In contrast, German manufacturing output growth slipped to the weakest since April 2016 as exports fell to the greatest extent since June 2013. Overall selling price inflation meanwhile also slipped from the near-record high seen in August but remained elevated.

In France, growth of output and new orders both slipped to the lowest since late-2016, though employment growth remained more resilient, albeit cooling slightly. Service sector growth was the joint lowest since the start of 2017 but it was manufacturing that fared the worst, seeing output growth almost stall at a two-year low as exports fell for the second time in three months. Intense competition meant selling prices rose only modestly despite one of the steepest increases in costs seen over the past seven years.

Elsewhere, growth improved only marginally from August’s 22-month low, rounding off the worst quarter for two years.

Chris Williamson, Chief Business Economist at IHS Markit:

A near stagnation of exports contributed to one of the worst months for the Eurozone economy for almost two years. Trade wars, Brexit, waning global demand (notably in the auto industry), growing risk aversion, destocking and rising political uncertainty both within the Eurozone and further afield all fuelled the slowdown in business activity.

Thankfully, the slowdown was limited to manufacturing. A buoyant service sector, boosted in part by domestic demand being supported by strong job gains, means the survey data are running at a level indicative of the economy growing by a solid 0.5% in the third quarter.

However, with new orders and backlogs of work rising at much reduced rates compared to earlier in the year, export growth evaporating and future expectations remaining close to two-year lows, the risks to future growth appear tilted to the downside.

Nikkei Flash Japan Manufacturing PMI

• Japan Flash Manufacturing PMI rises to three month high of 52.9 in September, from 52.5.
• Input cost inflation accelerates at fastest pace since March 2011.
• Geopolitical tensions weigh on sentiment, with Future Output Index dipping further.

The manufacturing sector business cycle continued along its upward path in September, according to the flash survey, continuing a trend which PMI data indicates first began just over two years ago. Indeed, business conditions remained robust despite a number of natural disasters over the past month.

Growth in the goods-producing sector continues to be supported by increases in new orders. Although recent demand pressures have been primarily driven by the domestic market, latest flash data pointed to the first rise in export sales since May amid ongoing global trade frictions.

That said, business sentiment dipped further in September to a 22-month low as firms remain uncertain to how international trade tensions could impact the Japanese economy.

There Have Never Been So Many Bonds That Are Almost Junk CFOs have been borrowing as much as they can get away with without being classed as junk. That means a bigger slice of bonds face a downgrade from investment grades.

(…) This summer for the first time more than 40% of the value of U.S. corporate bonds was rated BBB, just eking over the line into investment grade, and an even higher proportion was BBB in Europe.

Back in 2007, bond spreads were a little lower than today, but a smaller slice of bonds was on the bottom rung of investment grade and so at risk being downgraded to junk; only 26% of U.S. bonds were rated BBB, and only 20% of eurozone bonds, according to Intercontinental Exchange data. (…)

The scale of the debt at risk of downgrade to junk is already frighteningly high, despite decent economic growth. Hans Lorenzen, a credit strategist at Citigroup, calculates that just the weakest BBB-rated bonds with a negative outlook or on review for downgrade, plus those where the issuer has other junk-rated bonds, amount to about half the existing size of the $1 trillion U.S. junk market. In Europe those close to the edge would add about 35% to the €347 billion ($405 billion) junk market if all were downgraded, something that would surely create massive indigestion as investment-grade funds become forced sellers. (…)

Leveraged Loans Are Flying Off the Shelves Some caution that investors may be buying at the wrong time.

(…) Retail investors have poured cash into funds that buy loans, with $282 million of inflows into mutual funds and exchange traded funds in the week ended Sept. 12, the 10th straight week of money coming in, according to Lipper data. Pension funds have also been big buyers of credit products broadly, according to a report by Canaccord Genuity. And some $84 billion of collateralized loan obligations have been sold this year, a record pace, which fuel demand for loans by buying them and repackaging them into securities.

Investors are looking to buy instruments that pay floating rates, meaning their prices don’t fall as the Fed tightens monetary policy. The U.S. central bank is widely expected to hike rates when it meets next week, and futures markets also project increases in December and at least one more time next year. Loans are also attractive because they are first to be repaid if a company goes under, making them less risky than corporate bonds that are usually behind loans in the pecking order. (…)

Moody’s Investors Service in August highlighted how borrowers are eliminating investor protections on loans known as covenants. That could lead to lower recoveries in the next downturn, the ratings company said, predicting average U.S. first-lien term loan recoveries would fall to 61 percent, versus their 77 percent long-term historical average. For the second lien, recoveries could be 14 percent, compared with a 43 percent historical average.

In addition to weaker covenants, companies have taken on a lot more loan debt during this cycle, than they’ve had historically, and have comparatively fewer bonds. Those factors mean recoveries for first-lien loans could be closer to 50 cents on the dollar, said Tom Mansley, investment director at GAM Investments. (…)

More on disappearing covenants: Grant’s Interest Rate Observer notes this month that according to Covenant Review, less than 50% of newly issued leveraged loans capped the “dollar value of synergies and costs savings that promoters could use to fluff up EBITDA”, down from 80% in Q1’16.

If I understand correctly, investors, expecting higher interest rates, are smartly switching from bonds to leverage loans to eliminate the interest rate risk. Doing so, they also accept higher default risk …which normally comes with rising interest rates…

Banks also show an inclination for more risk taking:

During January-August 2018, newly rated bank loans from high-yield issuers grew by 6.3% year-over-year. The increased reliance on bank loans, especially for the initial finding of acquisitions and spin-offs, has been in response to an easing of bank loan covenants. An estimated 61% of 2018-to-date’s newly rated bank loan tranches were related to M&A; for the unfinished third quarter that ratio has soared to a nearly unprecedented 74%. In addition, the stronger preference for variable-rate bank loans, as opposed to fixed-rate bonds, suggests high-yield borrowers are not especially worried over the possibility of a steep and extended climb by benchmark borrowing costs. (…)

For the 12-months-ended August 2018, the newly rated bank loans from high-yield issuers have been distinguished by a record high $352 billion of loans graded single B or lower. Ba-rated loans set their 12-month high at the $334 billion of the span-ended November 2007, while the Baa group’s zenith was set at the $111 billion of the span-ended June 2016. (Please note that issuers having a high-yield corporate family rating of Ba1 or Ba2 often receive a Baa rating for their senior secured loans.) (Moody’s)

Thornburg Investment Management sums it up:

(…) The U.S. junk bond market now tops out at $1.2 trillion, doubling from $590 billion a decade ago. Meanwhile, the broad leveraged-loan market, in which most issues are covenant light, has grown to nearly $1.3 trillion, doubling in size just since 2012, according to Fitch Ratings. 

And non-financial corporate bonds rated BBB, just a couple rungs above speculative grade, have jumped nearly to $2 trillion, representing almost 40% of the U.S. non-financial corporate bond market, up from 31% in 2000. Aggregate BBB net leverage, or net debt-to-earnings before interest, taxes, depreciation and amortization (EBITDA) is running close to 2.9 times, up from 1.7 times in 2000. “It’s at a level that you would expect to see in a recession, when cash flows have fallen,” says Thornburg Portfolio Manager Lon Erickson. 

That decline in creditworthiness is also reflected in the U.S., and global high yield, for that matter. “The non-financial corporate debt burden today is higher than its peak before the 2008-09 financial crisis,” Moody’s Investors Service said in a May press release. “For investment-grade firms, median debt/EBITDA today is around 30% higher than it was in 2007, while for speculative-grade companies it is up about 10%. For many speculative-grade issuers debt capacity may have reached its limit, although investor protections continue to weaken.” (…)

Perhaps the biggest event risk is simply the constellation of corporate bond maturities in the near-to-medium terms, both in the U.S. and internationally. McKinsey points out that from 2018 through 2022, “a record amount of bonds—between $1.6 trillion and $2.1 trillion annually—will mature,” totaling $7.9 trillion in bonds already issued. “If current issuance trends continue, then as much as $10 trillion of bonds will come due over the next five years,” of which $3 trillion would come from U.S. firms, $1.7 trillion from Chinese companies and another $1.7 trillion from Western European corporates. Globally, non-investment-grade bonds almost quadrupled in a decade, reaching some $1.9 trillion by end 2017. Rather ominously, that reflects just 29% of corporate bonds with credit ratings. “There are a lot of bonds out there beyond those with ratings, making the debt maturity avalanche potentially worse than reported numbers, which focus only on rated debt,” Thornburg’s Erickson notes. 

In the U.S., McKinsey forecasts the share of speculative-grade bonds maturing in 2020 at 27%, up from 11% last year. That’s a $180 billion in 2020, though again, if current issuance trends hold, the amount will be even greater. But who’s to say today’s trends will hold? Issuers from challenged sectors such as retail and energy will likely be even more challenged in refinancing their maturing debt, particularly if rates continue to rise and the Fed’s “new neutral” rate isn’t as low as currently assumed. 

This isn’t to say high yield is bound to hit the wall in short order. But if tight high-yield spreads start to loosen, they can spike fast, “as investors scramble to get out of the worst stuff first,” Erickson points out, recalling that spreads spiked to nearly 20% in the Global Financial Crisis a decade ago.