Key junk market indicator points away from recession, Fridson says

By Paul A. Harris

Portland, Ore., Sept. 26 - The spread between the cyclical and defensive components of the high-yield index suggests that the U.S. economy is not presently in recession, nor is it likely to enter one in the next few months.

That's according to a report titled "Nowhere Close to Recession: Cyclical/Defensive Spread," by Martin Fridson, CFA and Camille Mcleod-Salmon.

They measured the option adjusted spread between the cyclical and defensive subindexes of the Bank of America Merrill Lynch High Yield Master II Index at plus 57 basis points, in a report published last week by BNP Paribas Asset Management and BNP Paribas Investment Partners.

On the other hand the last two recessions, in 2001 and 2008-09, have seen OAS spreads of plus 471 bps or more, the report states.

Warnings from elsewhere

Fridson and Mcleod-Salmon concede that this report surfaces against a backdrop of strong "recession" warnings.

One such warning emanates from the stock market. Between July 22 and Aug. 8, the Standard & Poor's 500 stock index fell by 17%. ISI Group states that since at least 1970 there have been only two declines of that magnitude that were not followed by a recession, in 1987 and 2002. Meanwhile six recessions have occurred since 1970.

Another argument for imminent recession arises from the concept of stall speed. U.S. gross domestic product grew by only 1.5% year over year in 2011's second quarter. A recent Federal Reserve Board study finds that when the 2% threshold has been breached, the economy has, without fail, either been in recession at some point over the past few quarters, or is about to fall into recession.

Jobs, Treasuries give clues

However in addition to the cyclical-defensive junk spread, other indicators also point away from recession, the report states.

Job growth, a key aspect of the business cycle, recently has been lackluster but not negative. Christopher Rupkey of Bank of Tokyo-Mitsubishi UFJ comments, "Nonfarm payroll jobs have to decline for three consecutive months for a recession. We don't even have one month."

"Recession nonbelievers also point to the currently steep Treasury yield curve. According to one venerable interpretation of the term structure of interest rates, a steep curve implies that investors expect stronger demand for credit and, by extension, higher interest rates in the future," the report states.

"Conversely, a flat or negatively sloped curve implies a weak economic outlook. Consistent with that interpretation, the basis-point differential between the two-year and 10-year Treasury yields was negative as of six months before the start of the last three recessions: negative 12 (Dec. 31, 1989), negative 43 (Aug. 31, 2000) and negative 4 (Dec. 1, 2007).

"In sharp contrast, the curve currently stands at plus 190 basis points."

Getting it 'real-time'

Information from the National Bureau of Economic Research, which officially dates U.S. recessions, tends to come with considerable lag-time, the report asserts.

As for the NBER, the business cycle dating committee's announcement that a recession has commenced comes well after the fact. In the last five recessions, according to the NBER website, the announcement followed the recession's start by five to 12 months. In the most recent case, it was not until Dec. 1, 2008 that the organization declared that a recession began in December 2007.

By contrast, the cyclical versus defensive OAS spread in the high-yield index can be measured on a daily basis, Fridson and Mcleod-Salmon assert.

"The nature of the Cyclical-Defensive spread reinforces our confidence in it as an indicator of an actual or imminent recession," they write.

"In the main, we believe, the widening and narrowing of the spread are not driven by top-down decisions to switch from cyclical to defensive industries or vice versa. For high-yield managers, the implementation of such allocation decisions is constrained by a combination of high transaction costs (a function of comparative illiquidity of the bonds) and investment guidelines that require extensive industry diversification.

"To a large extent, we believe, the cyclical group widens or tightens versus the defensive group because of bottom-up analysis and valuation of individual credits within the high-yield universe. Currently, the market's overall judgment on the names that constitute the cyclical subindex are not much riskier than those constituting the defensive index.

"If a recession were imminent, the projected cash flows of the cyclical names would be weaker, the credits would be assigned larger risk premiums, and the Cyclical-Defensive spread would be much closer to the key +471-bp threshold.

"Given that none of this is true at present, the yield premium on cyclicals implies that the U.S. economy is neither in recession nor likely to enter recession within the next few months."

Fridson is global credit strategist for BNP Paribas Asset Management, Inc. Mcleod-Salmon is a research analyst for BNP Paribas Asset Management, Inc.

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