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Credit Insights

Commodity Price Declines Indicate Global Economic Deceleration; Credit Spreads Widen Further

GDP not as low as it looked; Fed commentary specifically noncommittal.

With weakness in the global commodity markets, wild fluctuations in the Chinese stock market, and heightened idiosyncratic risk among domestic issuers, credit spreads in the corporate bond markets widened further last week. In the investment-grade space, the average spread of the Morningstar Corporate Bond Index widened 3 basis points last week to +159, its widest level over the past two years. In the high-yield space, the average spread of the Bank of America Merrill Lynch High Yield Index widened 4 basis points to +536. While the high-yield index is slightly tighter than its widest point reached in December last year, it is near its widest levels over the past two years.

Commodity prices have slumped over the past few months and picked up speed to the downside this past month. Softening global economic growth, especially in China, has reduced demand for industrial raw materials. From iron ore to coal, prices for basic material commodities have fallen precipitously. In fact, the price of copper (which has one of the highest historical correlations to economic activity) has fallen to its lowest levels since mid-2009. As these commodity prices have fallen, the average credit spread in the basic materials sector of the Morningstar Corporate Bond Index has increased almost 40 basis points since the end of last year to approximately +230 basis points over Treasuries. Of this widening, 30 basis points has occurred in July alone. This is the widest level this sector has registered since mid-2013. The basic materials sector constitutes 5.5% of our index and is responsible for much of the widening of the overall investment-grade market.

As global economic growth has slumped, falling oil prices have also taken their toll on the credit markets. After stabilizing around $60 per barrel earlier this summer, oil prices have resumed their decline, falling to $46 per barrel as of last Friday. The energy sector constitutes more than 10% of the Morningstar Corporate Bond Index and has widened 17 basis points during July to +210 basis points over Treasuries. This is the widest the sector has traded since March, when oil prices were last below $50 per barrel.

Weakening commodity prices have had an outsize impact in the high-yield market. As jump to default risk rises in these two sectors, credit spreads have widened drastically. For example, the average spread of the energy sector has widened almost 200 basis points since the end of last month to +900. Over the course of the month, the metals and mining sector has widened 167 basis points to +1,146. In the Bank of America Merrill Lynch High Yield Index, the energy sector accounts for 14% and the sectors that constitute the basic materials industry account for 12%.

Outflows from high-yield mutual funds and exchange-traded funds picked back up in earnest last week, as $1.7 billion of assets were pulled from the asset class. While the noise from the Greek debt crisis has quieted down (for now, anyway), weak commodity prices and wild swings in the Chinese stock market sent many investors to the sidelines.

Following the release of the second-quarter GDP growth rate, Robert Johnson, Morningstar's director of economic analysis, reaffirmed his projection for full-year GDP growth in the United States to range between 2.0% and 2.5%. To reach this full-year forecast, U.S. economic growth would need to average 2.7% in the second half of the year. While depressed prices of commodities will impair the credit quality of the companies in those sectors, this level of economic growth should be enough to hold down default rates, which will in turn support the high-yield market. In addition, the Federal Reserve still appears to be on course to begin raising short-term interest rates later this year, which may have the knock-on effect of pushing long-term rates higher. As such, with the expectation that default rates will remain low and interest rates appear poised to head higher, the high-yield sector, with its lower duration and higher credit spread, should continue to outperform the investment-grade sector in the second half of the year.

GDP Not as Low as It Looked; Fed Commentary Specifically Noncommittal
Second-quarter real GDP growth was reported at a 2.3% annualized rate compared with the first quarter. While that growth rate missed Johnson's forecast of 3.0%, it was affected by a significant revision to the first-quarter growth rate. Originally, real GDP for the first quarter was reported to be a decline of 0.2%; however, that was revised to a 0.6% increase, resulting in a differential of 0.8%. If the second-quarter growth rate were adjusted for that revision, it would have been almost right on top of Johnson's estimate. Consumer spending dominated growth in the second quarter, accounting for 90% of the overall GDP growth rate; business spending was the most significant laggard last quarter, as capital investment declined slightly. It is hard to estimate just how much business spending was affected by a marked decline in oil prices and the resulting decrease in drilling and related spending, but it is a significant portion of the category.

The Federal Reserve released its statement last Wednesday following the July meeting of the Federal Open Market Committee. There were a few minor changes that indicate the Fed is more confident that the economy is expanding at a moderate pace and the labor market is been improving, although the Fed continued to highlight that inflation is running below its target.

In the following chart, we compare the last three instances that the Fed began to raise the federal funds rate versus inflation metrics, real GDP, unemployment, and labor force participation. While no two situations are the same, other than the drop in the labor force participation rate, each of the inflation and employment metrics are currently near or within the range of other recent instances in which the Fed was able to begin raising interest rates. Also of note is how long the federal funds rate has been kept at zero (which was supposed to be a temporary emergency measure to bolster the financial system during the 2008-09 financial meltdown) as compared with the relatively short amount of time that the fed funds rate had bottomed out in the past.

If employment continues to expand within expectations through the September FOMC meeting, that may be enough evidence to finally push the Fed to begin to raise the fed funds rate. While no one expects the fed funds rate to surge higher in the short term, even a modest increase will begin the process to normalize monetary policy that has been held at an emergency rate of zero for almost seven years.