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Surprise Events and the Economic Cycle

Author: GlobalMacro Partners

June 5, 2020

In today’s age of digital technology, we are faced with a never-ending stream of bad news that often creates high levels of market uncertainty. The good news is that it creates a continuous stream of opportunities for astute bond investors to capitalize on (1) the economic cycle and (2) surprise events.

In today’s markets the MACRO drives the MICRO, and investors have become intensely focused on any news (good or bad) that may effect the economic cycle, and any surprise event that could send us into a recession or that may present unique opportunities for individual credits.

Economic Cycle

Opportunities are continuously created because every country moves through an economic cycle in its own time; and these cycles create buy, hold and sell opportunities country by country, and credit by credit.

This slide demonstrates the typical economic and credit cycle that an individual country may experience, as well as the historical behavior of a few key indicators as each individual country passes through the four stages of an economic cycle.

These indicators include:

  1. the direction of GDP and CPI
  2. whether credit quality improves or deteriorates
  3. whether credit spreads widen or narrow, and
  4. whether credit sensitive or high-quality bonds have historically outperformed.

While unique behaviors can occur, this has been the typical pattern of the economic, credit and bond market cycle over the past 100 years since 1920.

The reality is that the more countries you have in your investment universe, the more non-correlated economic and bond market cycles you can harvest to generate superior risk adjusted performance within an investment portfolio. Investors that limit their portfolio to just one country, only have one cycle to harvest.

Surprise Events

History has shown how the bond market has responded to the economic cycle and the occurrence of surprise events. As the economy nears a recession or if a surprise event occurs, credit spreads widen and then ultimately narrow once again.

In addition to the economic cycle, every so often, black swan events occur that create price disconnects and unique investment opportunities within the bond market.

A black swan event is a surprise event that wasn’t anticipated or expected, and therefore it wasn’t discounted into market prices. A good example of a Black Swan Event would be the Coronavirus Pandemic that began in March of 2020.

We are familiar with thinking of these events on a global or macro stage, but individual companies can have their own “Black Swan Events” regardless of the larger economic picture going on around them.

Economic Cycle & Surprise Events

At the end of the day, bond investing is all about how the bond market responds the economic cycle and the occurrence of surprise events.

To demonstrate, we created a historical chart that graphs the monthly closing yields of three different benchmarks.

Index Definitions

Recession: Recession dates per NBER; 10 Yr Govt: 10 Year Treasury Constant Maturity Rate; IG Corporate: ICE BAML US Corporate Bond Index; HY Corporate: ICE BAML US High Yield Index.

  1. In red we show credit sensitive high yield corporate bond, using the BAML US High Yield Bond Index
  2. In green we show high quality investment grade corporate bonds, using the BAML US Corporate Bond Index
  3. And in blue we show the 10-year US Government Bond Yield

We also include recessions as referenced by the grey bars, as well as major events that occurred since 1986, so you can see historically how the spreads widen and narrow around recessions and events.

What you will notice is that as the economy nears a recession, or if a surprise event occurs, credit spreads widen and then ultimately narrow once again.

Widening and narrowing credit spreads are a normal occurrence, and they create the investment opportunities within the global bond market to allocate between high quality investment grade bonds and lower quality credit sensitive bonds within a portfolio on a macro level. And individual credits may experience events and widening and narrowing on their own, irrespective of the larger environment, creating opportunities for individual credit selection all through a full credit and economic cycle.