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Credit Insights

First-Quarter Economic Growth Sluggish, but Corporate Credit Spreads Tighten Anyway

Most economists had predicted a much larger increase in consumer spending.

Economic growth for the first quarter of 2017 slowed to a 0.7% annualized rate compared with a 2.1% rate in the fourth quarter of 2016. This represents the slowest rate of economic expansion over the past three years. Even though consumer confidence has recently slipped a bit, both confidence and equity markets have generally been on an uptrend during the quarter; a major determinant of the slowdown was the 0.2% increase in consumer spending, which was the slowest pace of growth since 2009.

This slowdown in consumer spending accounted for the greatest differential between the actual reading and consensus estimates. Given increases in payrolls, wage growth, high consumer confidence, record-high equity markets, and moderate gasoline prices, most economists had predicted a much larger increase in consumer spending. A decrease in private inventories and imports also hampered economic growth. On a positive note, business investment picked up rapidly. This type of spending typically creates a strong tailwind for future economic growth as it enhances productivity and efficiency.

In our Second-Quarter 2017 Corporate Credit Market Insights published March 28, we noted that Robert Johnson, Morningstar, Inc.'s director of economic analysis, expected GDP growth in the first quarter would only be about 1.0%. At that time, his estimate was already well below the average consensus expectations of Wall Street economists. While economic growth came in slightly below that estimate, Johnson continues to expect economic growth will rebound toward a more normalized level in the second quarter. Johnson forecasts second-quarter GDP growth to increase to 2.1%, and for the full year, he continues to estimate GDP growth of 1.75%-2.0%.

Even though first-quarter GDP growth came in much lower than consensus expectations, the equity markets rose and corporate credit spreads tightened. Although revenue growth remains elusive, reported earnings for the first quarter were generally in line with expectations. Investors appear to be looking past the dour economic growth of the first quarter toward a pickup in the second quarter. In addition, many investors expect that possible revisions to tax and regulatory policies enacted by President Trump's administration will reinvigorate economic growth and earnings.

The average corporate credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 2 basis points over the course of last week to +121. In the high-yield market, the Bank of America Merrill Lynch High Yield Master Index tightened 22 basis points to end the week at +375. In the equity markets last week, the Nasdaq index broke through 6000 to new highs and the S&P 500 rose 1.5%.

While current levels in the corporate bond markets are wider than their historical lows of 2007, they are significantly tighter than their long-term averages. For example, the average spread of the Morningstar Corporate Bond Index is 46 basis points tighter than its long-term average of +167 since the end of 1998. In the high-yield market, the average spread of the Bank of America Merrill Lynch High Yield Master Index is 234 basis points tighter than its long-term average of +609 since the end of 1996.

As an indication of how tight corporate credit spreads have become compared with their historical averages, since the beginning of 2000, the average spread of the Morningstar Corporate Bond Index has registered below the current level only 26% of the time. The preponderance of the time that the index was at a level tighter than the current credit spread occurred during the buildup to the 2008-09 credit crisis. In 2004-07, corporate credit spreads were pushed to historically tight levels as new structured investment vehicles were engineered to arbitrage the differentials in expected default risk. But once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised.

In the high-yield market, corporate credit spreads are even tighter compared with their long-term historical averages. Based on the current spread level, the average spread of the Bank of America High Yield Master Index has registered below the current level only 16% of the time, also mainly during the run up to the 2008-09 credit crisis.

While there was a moderate amount of outflows in the high-yield sector over the prior two weeks, fund flows were able to edge higher last week. According to our data, among the high-yield mutual funds and exchange-traded funds, fund inflows increased $0.2 billion as inflows into ETFs outweighed outflows in open-end mutual funds.

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