Bear Season Isn’t Over

Corporate borrowing is not about to get any easier as the economy slows down.
Joseph RadiganDecember 1, 2000

If you thought the markets had a wild ride in 2000, well, don’t unbuckle your seatbelt just yet. The roller coaster hasn’t stopped rocking. At least, that’s the message from the investment team at MFS Investment Management, which was in New York this week to present the financial press with its annual year-end investment outlook.

While several equity fund managers spoke, from the perspective of corporate issuers, perhaps the most interesting comments came from James Swanson, the manager of the multi-sector fixed- income portfolio and an MFS senior vice president.

Plain and simple, Swanson said, “We’re in a slowdown, and we’re seeing a confirmation of that in the data from the U.S., Europe and Asia.”

Friday morning, the National Association of Purchasing Management said its manufacturing index had fallen below the all-important 50 level for the fourth consecutive month. An NAPM reading below 50 implies a contraction in the manufacturing sector.

On Thursday, the Commerce Department said personal income had dropped 0.2 percent in October, while the Labor Department said first time unemployment claims were at their highest level in two years.

The data released this week adds to the stream of statistics in recent months that have pointed to a slowing economy.

What’s more, as Swanson noted, the retail sector in the U.S. has been getting weaker, and capital expenditures are also down. The blame can be placed on the usual suspects – – high oil prices and interest rates and lenders who are tightening credit.

But this slowdown has actually been a goal of central bankers. Particularly in the U.S., the Federal Reserve has sought to wring what it believed to be speculative excess out of the system.

Now that they’ve achieved zero price growth and raised the real cost of funds, will the Fed be ready to cut short term interest rates in 2001? Swanson said the answer is yes. But it won’t happen immediately.

Part of the reason for this is the timetable the Fed usually works with. The Fed’s policy making group, the Federal Open Market Committee is scheduled to meet again in mid- December. At its last meeting a month ago, it still maintained a tightening bias. It’s not likely that the Fed will move so quickly to cut rates when it so recently was still publicly holding on to its vigilance against inflation.

“The Fed is usually very deliberate and cautious,” Swanson said. Unless there’s a major disruption in the markets, such as an international economic crisis comparable to the Russian problems and the Asian meltdown in 1997 and 1998 or a large bank with an extreme deterioration in its loan portfolio, the Fed probably won’t feel any pressure to ease until its March meeting at the earliest.

That will make the next three to four months rough indeed for the corporate bond market. Particularly during the past week, there’s been a growing suspicion that the Fed may have succeeded a little too well in its attempt to achieve a soft landing. Rather, the economy may fall to a recessionary Earth with a thud.

We aren’t in a recession yet, but Swanson said that as long as the current environment persists, bond investors just won’t have the confidence to buy up new issues, and corporate issuers will struggle to sell any bond offering to the markets.

“It’s very difficult to get anything done right now,” Swanson said. “The window is not shut, but it is slamming on their fingers.”

“If you have to get something done, you’d better be real good quality,” he continued. “There better be no questions about inventory or receivables. You also have to be in a niche that’s still in favor. Utilities have held up well, but God forbid if you’re in the telecom sector.”

Swanson continued, “There is some demand, but every issue that has come to market, they’ve had to raise the yield 30 to 40 basis points. We’re definitely in a credit squeezing environment.”

In the domestic markets, the rise in funding costs is undermining the business case for some projects. Many capital projects are simply being put on hold or ignored. With corporate issuers scaling back their capital spending because of the credit squeeze, the economic expansion of the past decade is running out of fuel.

Fortunately, bond fund managers have cash on the sidelines, so once the bond market recovers, money will be put to work, Swanson said. But money managers are going to wait out the next three to four months and want to see a sign of recovery before they make any commitments.

That will come about in one of two ways. Either the economy will come back on its own, without Fed intervention. If that scenario comes it pass, it will mean that the Fed timed its rate hikes perfectly and succeeded with wringing the speculative excess out of the system.

The dot com failures we’ve witnessed this year were simply the over-leveraged firms at the margins. The companies still standing at the end of the first quarter will be the healthy ones, and money managers will have the confidence in their business prospects to buy their bonds.

Or, if the business failures spread beyond the margins and lead to a wider economic slowdown, the Fed will have to cut rates aggressively. As short-term interest rates fall, the yield curve will lose the inverted slope it’s had for more than a year. Corporate bond yields will look attractive again, and that should free up credit.

“What you’re looking for is a more steeply defined yield curve,” Swanson said. “The market will then say, ‘We see growth ahead’. Corporations will get their confidence back, and issuers will come to market.”

It’s just that getting there won’t be easy.