Washington gridlock won't change late-cycle realities

Savvy investors have spent a sleepless night as the results of the US midterm elections rolled in. The Democratic Party worked tirelessly to win the House, and today they claim victory; the outcome, however, will be government gridlock. But will these results change the cyclical course of the financial market? It’s unlikely.

The reality is that, regardless of the midterm, outcome, the late economic cycle has already started, and US politics can only delay or accelerate the coming of a recession.

With a Democratic House and a Republican Senate, we’ll see Washington tied in a knot. The Republican fiscal proposals are unlikely to pass, and the current congressional spending will likely be not altered for the next year. The economy is set to slow down as the fiscal stimulus fades and the investigation into President Trump’s fortune will continue to leave impeachment as a possibility. This will not leave Trump any other choice but to focus on foreign policy and to continue to expand tariffs as trade war risks escalate.

This will obviously have serious consequences on the US yield curve and markets as whole. While it may not be necessary for the Federal Reserve to continue on as hawkish a path as it has followed of late, and while Fed chair Powell might slow down rate hikes in 2019, trade war escalation may weigh negatively on long-term yields. This means that while we will see a steepening of the yield curve for the next couple of months, the shorter part of the curve could retreat faster than the longer part of the curve will rise because long-term yields will be constrained by trade uncertainties.

The slow degradation of credits that we are witnessing now will continue and by the end of next year and the beginning of 2020 we might start to see a serious repricing of the credit spreads that will affect equity valuations as well.

We are already seeing the first signs of distress in the credit space. Last month was the first month since August 2017 in which leveraged loan performance closed negative. Although we are talking about a loss of just 0.03% according to the S&P/LSTA Leveraged Loan Total return index, retails investors pulled a considerable amount of money out of leveraged-loan funds on fears that this could be the start of a more major move.

US politics can only delay or accelerate the coming of a recession.

The leveraged loan space has been under increasing scrutiny over the past few years as companies have taken advantage of both the low-interest rate environment and investor appetite for higher-yielding credits to borrow more and more money. Now that credit conditions are tightening, many are of the view that certain of these covenant-lite loans could suddenly default, giving the first blow to a house of cards that has been building up since the financial crisis of 2008.

This makes sense, but it's important to flag that identifying bubbles is not the same as timing their bursts. Although it makes sense to prefer quality over yield, it may still be too early to pull out of higher-yielding instruments as the economy continues to be underpinned by strong fundamentals. 

Regardless of what happened in the midterm elections, we believe that the US credit space will continue to be supported for the next couple of years. As thing settle down after the vote, investors have plenty of choices regarding where to put their money to work.
We continue to be overweight US corporate versus Treasuries. The steepening of the yield curve may be painful for holders of longer-term Treasuries, while the upside of holding short-term Treasuries is limited given that the Fed may still need to hike rates in H1’19 despite an overall less hawkish stance.

This is the reason why corporates play an interesting role in an environment of a robust economy amidst uncertain politics.

While the US yield curve reprices, economic fundamentals will remain strong the next 18 months, supporting the valuations of high-grade corporates. We believe that the shorter part of the curve in the US high-grade space offers interesting opportunities in an uncertain time; we particularly like BBB-rated corporates in defensive sectors.

We are not expecting a major change of heart from the Fed tomorrow. In our view, Powell will probably ‘copy-and-paste’ from previous statements while waiting to see how the political scene plays out over the next few months. This should leave investors plenty of room to position themselves as they please, but it’s important to remember that credit quality is rapidly becoming a priority.