Fixed Income Archives

Notes from the Desk: 3 Reasons Now is the Time to Sell High-Yield

Posted on September 25, 2019September 25, 2019 by Sage Advisory

by Ryan O’Malley, Fixed Income Portfolio Strategist

In recent weeks, Sage has become more cautious on lower-quality corporate bonds. Our caution is based on the following signals.

1. Abnormal Performance – High-yield bonds have performed well on an absolute-return basis this year, returning nearly 12% in 2019. Years of double-digit returns for high yield are rare and are typically followed by much weaker returns the following calendar year.

2. Relative Value – High-yield bonds have dramatically outperformed investment grade corporate debt this year, and particularly in the past few months. The spread premium paid by high-yield bonds compared to investment grade bonds has narrowed to its lowest level in 2019 and is near historic lows.

3. Signs of stress in the weakest parts of the market – Despite strong overall performance in the high-yield bond market, there are signs of stress. One such signal is the increase in the number of bonds trading at “distressed” levels. “Distressed” bonds are defined as those issuers who’s spread to the relevant U.S. Treasury exceeds 1,000 basis points, or 10%. The number of bonds trading at “distressed” levels has increased by 63% in the past 12 months.

Sage Positioning

As a result of this changing view, Sage has elected to trim high-yield exposure where we had individual bond positions – taking profits on some longstanding trades, including debt issued by Hilton Worldwide, T-Mobile, Ardagh Group, Cheniere Energy Partners, and Western Digital. Sage has also tactically shifted away from “crossover” credits, or credits that hold investment grade ratings from one agency and high yield from the other.

Investment grade spreads often follow trends in the high-yield markets, so Sage has also shifted its investment grade exposure away from riskier credits and towards higher-quality ones.

*Source on all charts is Bloomberg.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

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Hold the Door – Policy Optimism Could Provide a Good Exit Point

Posted on June 24, 2019June 25, 2019 by Sage Advisory

by Rob Williams, Director of Research

Policy Pivot and Markets

The Fed and the other major central banks have turned decidedly dovish in the face of trade concerns and a more obviously weakening global economy. This has bolstered risk markets and sent global rates falling. We believe this trend is likely to continue in the near-term, as the policy shift has been dramatic and central bank dialogue has highlighted the commitment to easing and stimulus as needed.

Bad is Good Again

We appear to be entering a period we have become all too familiar with in this recovery; one where bad data equals good returns – all due to policy expectations. As shown below, economic data has been surprising to the downside while the S&P 500 keeps climbing. This suggests staying risk-on in the near-term. Unfortunately for investors, the difficult questions have yet to be answered. Namely, is this policy shift a temporary boost that will reverse the economic slowdown, or the beginning of a long easing cycle to manage us through a recession?

Pivot vs. Precursor to Recession

Only time and the evolution of data will give us the true answer, but we can look back and see some historical precedence as to when the Fed paused or eased temporarily between tightening regimes. Over the last 40 years we have had three easing cycles, which were all associated with recession. We have also seen the Fed pivot four times in response to market and economic stress.

Good for Bonds Either Way, but Risk Asset Outcomes Diverge

Examining historical returns of these two types of easing periods highlights the fact that bonds benefit from easing, no matter the outcome. But the fate of risk assets is ultimately tied to the ability policy has to affect the actual data.

Conclusion – Hold the Door

While we would not be hitting the exit button with respect to risk assets at this time, given policy support, we would keep the door cracked open and ready for an exit. Although we expect easing policy to affect asset prices, we are skeptical that it will have any meaningful impact on actual growth. Global rates are already low, and shaving even 100 basis points off rates over 12 months is unlikely to be a game changer. If risk markets continue to push higher on policy optimism in the face of poor global growth momentum, we would view this as a good opportunity to lower risk.

*Source on all charts is Bloomberg

China Gets Serious – Tightening the Screws on Rare Earth Elements

Posted on June 3, 2019June 3, 2019 by Sage Advisory

by Komson Silapachai

As tensions between China and the United States escalate beyond trade, both sides are gearing up for a protracted economic conflict. One sign of that escalation lies in an esoteric part of the periodic table – rare earth elements (REEs).

We’ve written about rare earth elements before, most recently in August 2018. Rare earth elements are small but critical parts of many technological applications, including defense, mobile phones, energy, and automobiles. China controls upwards of 80% of U.S. imports of rare earths, and media reports have hinted that China could restrict supply to the U.S., which would threaten to disrupt the supply chains of many of the United States’ largest companies.

This move by China is a significant escalation in the trade war, as this is one of the areas of high leverage for China due to its dominant position as a producer and the reliance on REEs by the U.S. manufacturing sector in consumer, medical, defense, and energy-related applications. China’s proposal threatens a critical area of U.S. manufacturing and technology with comparatively low level of economic fallout that would harm China itself. This escalation of trade tensions bolsters our base case scenario of negotiations stretching into at least 2020, subjecting financial markets to episodes of large swings both negatively and positively as negotiations are playing out in headlines and social media.

What are Rare Earths?

Rare earth elements are a group of 17 chemical elements on the periodic table that tend to occur together in nature. These metals have many similar properties, and they are often found together in geologic formations, such as coal seams and deposits. They were named “rare earth elements” because most were identified by scientists during the 18th and 19th centuries as “earths,” which were defined originally as materials that could not be changed further by heat and were thus considered to be rare in nature. Contrary to historical findings, REEs are moderately abundant but difficult to extract from surrounding matter because of the way in which they bond freely with one another in minerals and clays. As a result, these natural properties make for a difficult extraction effort involving significant capital investment, time, and adverse environmental chemical processes.

China is the world’s leading producer of rare earth elements, having started production from its coal deposits within inner Mongolia in the early 1980s. Today, China controls over 37% of the estimated worldwide reserves of REEs and currently over 89% of reported global production. As a result, China wields significant power over this critical global supply chain and continues to gain market share. Politics in other countries are also contributing to China’s strength in this area. Recently, Lynas Corporation, an Australian rare earth mining company, is facing the closure of its Malaysia-based Advanced Materials Plant by the Malaysian government. Given that the plant produces 10% of the world’s output in rare earth oxides (REOs), the potential closure of this plant means the second largest REO producer could potentially shut down, thus augmenting China’s power position in this strategic group of industrial commodities.

Recent Developments and Implications for Our View

China has the “strong hand” in terms of rare earths and has used it as an economic weapon in the trade war. After the U.S. imposed additional tariffs on Chinese imports on May 10, China responded in kind, but one of the targets of the retaliatory tariffs was interesting. According to Bloomberg, China targeted shipments of rare earth elements used in electric cars from the only U.S. rare earth producer – MP Materials, based in California. China is the world’s largest producer of electric vehicles, and the tariffs will constrict MP Materials’ margins and skew the competitive landscape in rare earth production in favor of China. On May 29, media reports out of China continue to hint at the prospect of a rare earth export restriction against the U.S. in response to the United States’ blacklisting of Huawei Technologies and depriving its supply chain of crucial components from U.S. suppliers. Two days later, on May 31, Bloomberg reported that Chinese officials have readied a plan to restrict REE exports, conditional on a further dispute.

Our base case for trade tensions is a protracted negotiation period stretching into at least 2020. This view is predicated on the fact that the structural issues at play – the United States’ desire to protect its status as the world’s technology hub and China’s need to transition its economy into a value-added producer from a low-cost manufacturer are fundamentally at odds. A restriction on REEs is a significant escalation by China given it’s an area that cuts to a key vulnerability for the U.S. manufacturing and technology sectors and doesn’t have much of a negative effect on the Chinese economy in isolation. We think concerns over sales of Treasuries by China are less likely in the near term, as a disruption in Treasuries could impair the value of China’s USD reserves.

Tail risks abound. The probability of no deal in the form of an indefinite cessation of talks is higher given recent rapid escalation, and financial markets are not priced for a scenario in which that happens. Trade negotiations between the U.S. and China are moving from the realm of diplomacy into an economic war.

All eyes now move to Presidents Trump and Xi’s scheduled face to face at the G20 summit on June 28^th, as the stakes continue to march higher.

The U.S. Economy – Signs of A Sneaky Slowdown

Posted on May 21, 2019May 21, 2019 by Sage Advisory

By Komson Silapachai

We are in the longest U.S. economic expansion in modern history.

Barring a black swan of epic proportions this month, the U.S. economy will break the record in June for the longest expansion since 1854. The current leader, which is soon to be surpassed, is the 1990’s economic expansion, which lasted for 10 years. Is this a cause for a celebration, or is the economy due for a downturn?

Economic expansions don’t die of old age. Just because the expansion has lasted this long doesn’t mean it should end. In fact, there are many positive indicators of why this expansion should continue. Private-sector balance sheets remain strong, as financial assets and home prices are near all-time highs. The labor market is solid – the U.S. unemployment rate stands at 3.6%, just 0.2% from its all-time low. Inflation remains subdued and serves as a tailwind to the economy, as the Federal Reserve has not moved to tighten conditions.

An additional positive indicator, the Chicago Fed’s National Financial Conditions Index, which indicates conditions in debt, equity, and “shadow” banking systems, illustrates that financial conditions are at their easiest levels post-crisis.

However, we’re starting to see initial signs that the economy could be softening. While we don’t believe these indicators point to an imminent recession, the economy is experiencing a material slowdown that warrants observation for the remainder of the year.

1. Business Loan Activity

The Federal Reserve’s Senior Loan Officer Survey’s measure of business loan activities points to moderation in business investment. The percentage of loan officers reporting stronger demand are the lowest in the post-crisis period, while loan standards have moved tighter since the second half of 2018.

2. Transport Volume

Key transportation indicators have turned negative. The Association of American Railroads has reported a slowing in U.S. rail traffic volumes, with total volumes falling in the first 17 out of 19 weeks in 2019.

3. Industrial Output

Capacity Utilization, which measures the percentage of realized potential industrial output and economic slack, has been declining since its peak in October 2018 and is at a 14-month low.

4. Manufacturing Demand

The widely followed ISM Manufacturing Purchasing Manager’s Index (PMI), which surveys purchasing managers at over 300 manufacturing firms, has moved sharply lower in recent months. A PMI index above 50 indicates an expanding economy, and a move below 50 indicates a contraction. While the indicator stands in expansionary territory at 52.5, it has declined from its peak in August 2018 of 60.8. A sustained move below 50 would signal a serious slowdown, if not a recession; however, we are not there yet.

5. Economic Activity

The Chicago Fed’s National Activity Index, which is a composite of 85 indicators of national economic activity, has turned lower and points to below-trend growth in recent months.

As the U.S. economy moves into its longest expansion in modern history, we are seeing signs of a slowdown bubbling under the sanguine labor market and easy financial conditions. Whether the dip is transitory, as it was in 2016, or a herald of a larger slowdown remains to be seen. It all depends on the outlook for monetary and fiscal policy, as well as a potential fallout from slowing global trade.

China’s Conundrum: Why a Trade Deal Remains Out of Reach

Posted on May 10, 2019June 6, 2019 by Sage Advisory

by Komson Silapachai

It was the winter of despair, it was the spring of hope, we had everything before us, we had nothing before us. Charles Dickens’ timeless words in the opening of A Tale of Two Cities serves as a poignant reminder of the fear and greed that dictate the movement of financial markets. The trade war was all but resolved; now the deal is effectively off the table.

We think the bar is high for the U.S. and China to strike a deal on structural issues, such as changing China’s laws on forced technology transfer and the protection of U.S. intellectual property. China’s economic development objectives are fundamentally at odds with U.S. interests. Our base case is a prolonged negotiation period with any agreed-upon deals centered around correcting the U.S./China trade imbalance rather than the structural issues around each country’s economic system. In this scenario, we see a prolonged period of uncertainty in which risks of shocks to global growth (especially in Asia), investor sentiment, and asset prices remain squarely on the downside.

To process the current U.S./China trade battle requires a broader look at the larger structural issues that have created the underlying causes of tension.

China’s Economic Development is the Antithesis to U.S. Interests

China’s rapid ascent to the world’s largest economy is attributed to its role as the preeminent low-cost manufacturer. However, China is currently facing the problem of a “middle income trap,” a stage in economic development in which a country loses its competitive edge as purely an exporter, and concurrently, is unable to keep pace with developed countries in the production of value-added goods, such as high technology. Avoiding this outcome is nothing short of an existential issue for such a large, highly-indebted, populous nation.

To transition to a developed economy, China is undertaking a historic transformation: from a low-wage manufacturer dependent on external demand to a high productivity, high technology, value-added producer with increased dependence on its domestic economy. “Made in China 2025,” a state-led industrial policy introduced in 2015, addresses the methods by which China aims to make this transition. According to James McBride and Andrew Chatzky at the Council on Foreign Relations, China’s methods include setting explicit targets, providing direct subsidies, acquiring foreign tech companies, mobilizing state-backed companies, and forced technology transfer.

Therein lies the “structural issues” inherent in a trade agreement – China’s objectives are at the United States’ expense. The U.S. stands to lose its competitive edge as the epicenter of technology and value-added goods; while on the other hand, China cannot afford to deviate from its transition to a developed economy due to the looming middle-income trap.

On May 3, Reuters reported that China sent a diplomatic cable in which it “had deleted its commitments to change laws to resolve core complaints . . . theft of U.S. intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation.” At the eleventh hour, China couldn’t commit to abandoning its best hope for an economic transformation.

The U.S. subsequently raised tariffs on $200 billion of Chinese goods to 25% at 12:01am on Friday, May 10. The tariffs are expected to have a material adverse effect on the Chinese economy – Citigroup economists expect the effect of incremental tariffs to result in a -0.5% reduction in Chinese GDP and removal of 2.1 million jobs in China over the medium-term.

Market Implications

Here is our outlook regarding trade for the coming months. Our base case is a prolonged negotiation period stretching into 2020, which should result in a period of higher uncertainty in markets balanced with continued policy support from global central banks. Less probable cases include a near-term trade agreement that could take place in two forms: a correction of the U.S./China trade imbalance with less focus on structural issues (more probable), or a trade deal in which China agrees to change its laws around competition and intellectual property (less probable). The risk of a no-deal is not zero, but we believe it is less likely as it is mutually destructive, and both countries could continue to “kick the can” of negotiations further and further into the future. The table outlining our outlook is below.

Five Questions to Ask your Municipal Bond Manager

Posted on May 6, 2019June 6, 2019 by Sage Advisory

by Jeffrey Timlin

At current valuations, should I wait to invest cash in the municipal market?

All things being equal, history has shown that bonds outperform cash over most time periods. Although municipal valuations are not super attractive right now, every asset class is rich and trading at or near their all-time highs. The benefit of municipal bonds is not only tax-free income, but as an asset class, it is negatively correlated to the broad market during market downturns. If equities enter a corrective phase, municipal bonds typically hold up well and may even experience modest price appreciation.

When will the strong technical environment normalize?

To be sure, the record municipal cash inflows experienced year-to-date cannot last forever. The caveat to that remains the ongoing reduction in new issue supply, as well as the elevated levels of maturity and coupon payments coming due. Historically, periods of significant outflows have coincided with negative returns as investors and funds alike were forced to liquidate positions to raise cash. Unlike those periods, the current environment shows mutual funds sitting on higher levels of cash and they are cushioned by higher levels of maturity and coupon roll-off. Lastly, as a result of the decade-long recovery, a record number of millionaires now reside in the U.S. – more than 11 million people. These millionaires benefit fully from the tax-exempt income offered by municipal bonds, especially the ones who live in high-tax states.

Are there any credit issues that I should be concerned with?

Overall, there are no serious credit concerns within the municipal market. Several well-known credits, such as the State of Illinois, City of Chicago, and Puerto Rico remain challenged and should be reviewed on a quarterly basis. Although mid-to-long-term issues do exist regarding pension and health care funding levels, there is not cause for immediate concern. Due to the monopolistic characteristics and taxation powers inherent in most municipal issuers, the municipal market remains one of the safest areas within the fixed income markets.

I am worried about losing money in fixed income. What can I do to protect myself?

Many investors overestimate the downside risk of municipal bonds. Over the past 15 years, a core municipal strategy that has an effective duration of approximately six years and invests in maturities out to 30 years only had two negative-return years: 2008 (-2.49%) and 2013 (-2.55%). Even on a quarterly basis, the worst return during that time was -4.17% in the fourth quarter of 2010, after Meredith Whitney’s bogus municipal default prediction. To put that into perspective, the worst quarterly return for municipal bonds has occurred to daily returns in the equity markets on a fairly consistent basis. For investors looking to minimize downside risk, municipal strategies with a duration of four years or less tend to offer an attractive yield, while limiting principal loss on a yearly basis.

Why does it take a few weeks to get my portfolio fully invested?

Municipal portfolio cash could be invested in a day or two, provided the investor is not concerned with valuations or optimizing their sector and credit profile. Unlike equities, which are constantly available, municipal bond supply ebbs and flows daily. A bond that trades today may never trade again if held by buy-and-hold investors. In addition, Sage is a value-based investor that screens the market for attractive offerings. A combination of new issue, secondary offerings, and bid wanted are utilized to source bonds at attractive levels. Each of these avenues opens and closes daily and takes time to access. Sage believes that having the patience to wait a few weeks to purchase the most attractive offering will pay dividends in the long run.

Auto Loan Losses: Navigating Through the Noise

Posted on May 1, 2019June 6, 2019 by Sage Advisory

by Seth Henry

Over the last few quarters, there have been numerous news headlines noting the rise in auto loan delinquencies. The headlines tell only part of the story, however, as many of the losses can be attributed to subprime auto loans, which comprise roughly 40% of the auto loan market.

Over the past decade, losses on automobile asset-backed securities (ABS) had actually trended downward and reached historic lows. This is due in part to the strong financial position of the American consumer. A decade of historically low rates combined with very low unemployment helped to keep the consumer in a stable environment and auto loan defaults relatively low. While it is true that delinquencies and losses have increased, this is due primarily to losses in the subprime portion of the auto loan market, which is $55 billion of the $140 billion market. Specifically, delinquencies and losses have increased for subprime issuers who have a poor track record for underwriting and managing risk.

While current losses on prime auto loans are higher than their historical lows (0.56% vs 0.30%), they are still very low and well within expectations.

Over the last five years, smaller-scale (non-benchmark) subprime issuers have seen losses increase from 7.60% to 9.90%, a much larger increase that weighs on the sector as a whole.

Despite subprime auto weakness, Sage believes that prime auto borrowers are in a healthy position and do not pose a systemic risk. Given the strong job market, consumer ABS is still a healthy sector with a compelling risk-reward value. The sector is largely AAA-rated, and a great alternative to other high-quality, lower-yielding assets.

Notes from the Desk: Is Now the Time to Extend Duration?

Posted on April 30, 2019June 6, 2019 by Sage Advisory

by Robert Williams

Cash and ultra-short fixed income investors continue to enjoy the fruits of nine Fed rate hikes. Yields on cash hover around 3% with relatively low interest rate sensitivity. However, with the Fed done raising rates, core yields now 60 basis points lower than six months ago, and the economy in the later part of the cycle, bond investors who tactically shifted to cash and ultra-short allocations should start to think about whether or when to extend out the curve. The decision to extend duration to a short or intermediate duration strategy depends largely on an investor’s expectation for the yield curve.

What is curve telling us and where does it go from here?

The yield curve has flattened to near zero, as it typically does during a Fed tightening cycle, usually as a precursor to an inversion and a recession. With the Fed signaling no further hikes and the U.S. still experiencing decent grow, curve inversion in the near-term appears unlikely. In fact, markets are now pricing in a probability, albeit low, of an interest rate cut as early as the end of 2019. Where we go from here requires an outlook call on growth and inflation. Below we outline our outlook in three scenarios, including their likely impacts on the curve.

Outlook Scenarios (Next 6-12 Months)

Base Case and Recession Expectations

Our base case is for low, but stable growth in the U.S.; a modest uptick in inflation, which keeps the curve flat; and a modest steepening bias possible. We see the greater risk of this backdrop eventually transitioning to weakness, rather than above trend growth, and expect the next directional move in the curve to be a steepening bias as the Fed cuts rates. This part of the scenario looks further down the road, as the curve and data suggest near-term recession odds remain low. While portions of the curve briefly inverted in March, it didn’t last more than a couple days and regardless, the lag time between curve inversion and recession or even market peaks are typically several quarters. Recent data trends in the U.S. have been improving, which has been putting more slope back in the curve, but not so strong as to put the Fed hikes back on the table and cause a flattening/inversion trend to resume.

Extending and Historical Returns

Given our outlook, the idea of at least beginning to consider a strategy extension makes sense given the higher probability of a flat-to-modest steepening environment and a more limited chance of near-term inversion or meaningfully higher long rates. We also looked at past curve environments to understand return differences historically when moving out in duration. We used the last four curve inversions referenced in the table below as a basis.

For each period, we calculated returns across cash, short gov/credit, and intermediate gov/credit across three periods:

Flattening: 6 months leading up to the inversion
Flat/Inverted: the inversion period
Steepening: 6 months after the end of the inversion period

The results illustrated below also support the idea that cash makes sense in periods when the yield curve is flattening during a tightening cycle, but that post-cycle it has made sense to move out on the curve.

Given our current outlook, likely curve scenarios, and historical returns data, cash and ultra-short strategies still makes sense, but investors should start considering at least a push out to short strategies. Further, as the curve continues to steepen near-term, the risk/reward will become increasingly favorable for extending to an intermediate duration strategy.

Trust Accounts Benefit from Tax-Exempt Income

Posted on April 23, 2019June 6, 2019 by Sage Advisory

by Jeffrey Timlin

Unlike the graduated federal income tax brackets that max out at 37% with taxable income at $500k or more, trust accounts benefit from owning municipal bonds at a significantly lower tax bracket. As the political and economic environment becomes increasingly uncertain, many high-net-worth clients are turning to trusts to protect their assets as well as provide a tax-efficient way to transfer assets to family members. In 2012, the American Taxpayer Relief Act (ATRA) added new net investment income tax (NIIT) brackets for certain trusts as shown in the tax table below.

Source: IRS.gov

For clients in non-grantor trusts, the benefit of owning municipal bonds is realized almost immediately since the maximum income bracket tops out at only $12,500. As an added benefit, by utilizing tax-exempt municipal bonds to produce income, the trust’s beneficiary could also avoid paying the 3.8% investment income tax associated with the Affordable Care Act of 2010 for a maximum tax savings of 40.8%. Depending on the state of residence, an allocation to in-state municipal bonds may further enhance the tax-efficiency of the income generated within the trust.

Since the inception of municipal bonds, high-net-worth individuals have successfully utilized the benefits of tax-exempt income. Along with tax-free income, investors have benefited from a high degree of principle protection and low levels of price volatility. To ensure the proper use of municipal bonds within a trust, please review the trust agreement with your financial advisor, tax accountant, and trust attorney. Once approved, allocating to municipal bonds could significantly reduce your annual tax liability.

Credit Quality at Regional Banks May Signal Economic Slowdown

Posted on April 22, 2019June 6, 2019 by Sage Advisory

by Ryan O’Malley

Will years of aggressive lending finally catch up with the U.S. economy at precisely the wrong time?

The U.S. economy is firing on all cylinders, with unemployment near record lows, labor force participation near record highs, and GDP growth and inflation moving along perfectly in line with the targets set by the U.S. Federal Reserve. Despite this rosy backdrop, signs of stress are appearing in one segment of the economy: regional banks.

Increasing Percentage of Leveraged Loans Among Regional Banks

According to a Moody’s survey of 38 regional banks, the percentage of leveraged loans at regional banks is increasing; 45% of regional banks expect their total amount of leveraged loans outstanding to increase over the next two to three years. Perhaps more concerning, nearly 50% of the outstanding loans held at these regional banks are unrated by Moody’s or S&P, reducing transparency for bank executives and investors. Overall, leveraged commercial loan exposure remains low at 3%, but the trend appears to be toward riskier credits, as banks struggle to compete with more aggressive non-bank lenders for business.

In addition to more leverage, there is some evidence that credit quality has started to suffer, leading to tighter lending standards. A recent survey by the Federal Reserve of 73 domestic banks found that in every loan category, a significant portion of banks expected to see loan performance “deteriorate somewhat.” These same loan officers surveyed indicated that their employers are beginning to exhibit a “reduction in risk tolerance” not seen in previous years.

Source: St. Louis Federal Reserve

This is classic “late-cycle” behavior by banks. When credit conditions start to deteriorate, banks begin to tighten lending standards, which can cause available credit to dry up right when the economy needs liquidity the most.

How is Sage Positioning for a Potential Credit Crunch?

At Sage, we are monitoring this situation closely. This trend will undoubtedly affect credit quality at the regional banks, but also has important implications for the overall U.S. economy.

Regional banks provide much of the lending to smaller businesses and the property development industry in the United States. If liquidity for these important growth engines begins to dry up due to concerns about credit quality caused by years of aggressive lending, the overall growth of the U.S. economy could begin to sputter.

Source: St. Louis Federal Reserve

The velocity of the money supply in the U.S. has been declining for years, indicating that consumers are transacting less on each dollar of supply put into the system than they were 20 years ago. This means that as the Federal Reserve has pumped more and more liquidity into the system, there is a smaller marginal increase in spending per dollar added. Recently, the Federal Reserve has begun to shrink the size of their balance sheet, which has raised concerns that liquidity is drying up in the banking sector, which could lead to less lending by banks going forward. Sectors that may be vulnerable to a slowdown in grassroots lending growth are to be avoided. This includes capital goods, real estate development, and consumer products.

This somewhat precarious situation has made us concerned that the positive business cycle of the past 10 years may be coming to an end. Given this view, we believe now is the time to begin trimming more illiquid positions that have experienced outsized price performance.