Moody's Warns on Rocketing US High Yield Spreads as Raising Risks of Recession

I am no fan of credit rating agencies, but current developments appears to prompt even the establishment to worry about the unpleasant ramifications of  deteriorating credit spreads on the economy.

From John Lonski at Moody’s (bold mine)

Volatility is king. Markets have been indifferent to claims that the latest broad sell-off of equities, lower quality corporate bonds, and certain emerging market currencies exaggerate any worsening of observable fundamentals. However, observable is the key adjective in the prior sentence. The two latest recessions were partly the consequence of markets not knowing the full extent of deteriorations in household and business credit quality. Not everything can be quantified, if only because some very critical things are hidden. Never underestimate the importance of thorough accounting. For now, it’s hard to imagine why the equity market will steady if the US high-yield bond spread remains wider than 800 bp. Taken together, the highest average EDF (expected default frequency) metric of US/Canadian non-investment-grade companies of the current recovery and its steepest three-month upturn since March 2009 favor an onerous high-yield bond spread of roughly 850 bp. Recently, the high-yield spread approximated 800 bp. (Figure 1.)

A wider-than 800 bp high-yield spread reflects elevated risk aversion that will reduce capital formation and spending by non-investment-grade businesses. In addition, ultra-wide bond yield spreads favor a continuation of equity market volatility that should sap the confidence of businesses and consumers.

M&A’s record pace may prompt more M&A-linked downgrades As derived from data supplied by Bloomberg, mergers and acquisitions (M&A) involving at least one US company soared higher by 19% annually to a new zenith of $3.336 trillion for yearlong 2015. A cresting by M&A may offer valuable insight regarding the state of the business cycle. The two previous yearlong peaks for US company M&A were set in Q3-2007 at $2.213 trillion and in Q1-2000 at $1.745 trillion. Recessions struck within one year of each of those peaks. Also, both previous peaks for M&A preceded a topping off of the quarter-long average for the market value of US common stock. (Figure 2.) For 2015, US-company M&A approximated 162.3% of pretax profits from current production and a record 18.6% of US GDP. The erstwhile record high ratio of M&A to GDP was the 17.8% of the year-ended Q1-2000. Year-end Q3-2000’s 215.1% still serves as the apex for the ratio of M&A to profits. During the early stages of an upturn by M&A, M&A-linked credit rating revisions show more upgrades than downgrades. For example, M&A-linked rating changes showed more upgrades than downgrades during 2010 through 2012, or after M&A activity had bottomed in 2009. However, M&A figured in more downgrades than upgrades once new record highs were set for M&A in 2000, 2007 and 2014. (Figure 3.)

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