More Defaults to Stoke Risk Aversion The world economy is in its worst shape since the Great Recession. And medium- to low-grade corporate credits will not escape the drag of global malaise. Ongoing industrial commodity price deflation constitutes strong evidence of a sagging world economy.
The price of crude oil has flirted with its lows of the Great Recession, while the base metals price index has slumped to levels last observed in the summer of 2009, or at the very start of the current recovery. The very strong correlation between the growth rates of the world economy and Moody’s industrial metals price index signal a downward revision of 2015’s world economic growth from 3.1% to a range of 2.5% to 3%. Base metals price deflation will keep benchmark interest rates low.
The latest 13-week average of the base metals price index was down by -25% year-over-year. For a sample beginning in 1982, fed funds has never been hiked when the moving three month average of the base metals price index was down by at least -15% annually. Moreover, such base metals price deflation was never accompanied by a year-to-year increase for the 10-year Treasury yield. Credit risk has pushed aside interest rate risks. The corporate credit cycle upturn may be past its prime, but doom does not necessarily impend.
High-Yield EDF Signals a Rising Default Rate Moody’s Analytics’ average expected default frequency (EDF) metric for US/Canadian non-investment-grade companies has climbed sharply higher. Up from the 3.6% of three months ago and the 2.3% of a year earlier, the average high-yield EDF metric was recently at 5.1%.
The latter suggests that the high-yield default rate may rise from August 2015’s 2.3% to 4.5% nine to twelve months from now, leaving the default rate above its 3.1% median of January 1996 through August 2015. (Figure 1.)
Defaults Can Soar If Profits Contract Accelerations by nonfinancial corporate debt outstanding lead the default rate higher, while decelerations, including the outright shrinkage of debt, help to guide the default rate lower. The latest quickening of corporate debt’s annual percent change from Q3-2010’s -6% contraction to Q2-2015’s 7% expansion complements expectations of a higher default rate.
However, the good news is that the annual increase of the moving yearlong average of corporate debt should fall considerably short of its 11% peak of both 2008 and 2000. Moreover, the record clearly indicates that the path taken by profits wields more influence over the high-yield default rate than does the growth of debt. For example, the default rate generates a correlation of -0.46 with the annual percent change of nonfinancial-corporate profits from current production, or core profits, compared with a -0.33 correlation with the annual percent change of nonfinancial-corporate debt.
When profits grow, the median default rate equals 2.9%, but when profits contract the median default rate jumps up to 6.8%. In view of how early September’s Blue Chip consensus calls for annual increases by core profits of 0.5% for 2015 and 4.1% for 2016, an especially jarring lift-off by the default rate seems unlikely. (Figure 2.)
