Investors buoyed by this summer’s recovery in U.S. stock markets should not relax their guard so soon because worries about corporate debt are likely to trigger another slowdown later this year, one prominent forecaster has predicted the world’s volatility specialists.
While the sharp fall in share prices in the first half of the year reflected concerns about future earnings due to inflation, investors have yet to factor in the effects of higher interest rates about companies with too much debt, Paul Britton, founder of Capstone Investment Advisors, told the Financial Times.
He warned that news of individual companies struggling to refinance their debt at affordable rates would spook markets again, likely in the fourth quarter or early 2023.
“We’re nearing the end of phase 1, a repricing of growth. Phase 2 is more interesting to me. It’s more of a credit cycle,” Britton said. “People are upset that they lost money, but there is no fear.”
“The headlines in the fourth quarter and the first quarter will be from people who have trouble refinancing and nervous investors will start selling,” he said. “In Q4 or Q1 it will go to fear.”
While many companies took advantage of extremely low interest rates in 2020 and 2021 to refinance their debt for very long periods of time, signs of strain are beginning to appear in debt markets.
Bankers last month postponed debt financing for the $16.5 billion acquisition of software company Citrix by Vista Equity Partners and Elliott Management, after struggling to find willing lenders. When companies have moved forward, they have often had to accept more onerous terms than in the previous 18 months. Banks such as Bank of America and Goldman Sachs that initially pledged to finance these deals have suffered nursing losses.
Capstone, which had $9.1 billion in assets under management as of July 1, is benefiting from choppy markets. Not only does it manage one of the world’s largest hedge funds specializing in volatility, it also helps institutional and high-net-worth clients protect their portfolios from extreme risk.
The investment group’s overall fund rose 0.8 percent in the first half and its spread fund was 14 percent higher, according to a person who has seen the results.
Global financial markets fluctuated widely in the first half as the S&P 500 entered a bear market amid concerns about a looming recession and tighter monetary policy from the Federal Reserve.
But as the equity market has found its most recent high, volatility gauges like Cboe’s Vix index have calmed; Earlier this week, the Vix closed below its long-term average of 20 for the first time since April.
A heated debate has divided the market over whether the rally in US stocks can last, particularly if the Fed raises interest rates more aggressively or faster than investors are betting on.
Britton, a former trader who benefited from the late-1990s volatility of the Asian and Russian crises but suffered losses in the 2008 financial crisis, said he did not expect the number of corporate bankruptcies to exceed in the last recession. The problems are likely to be concentrated among companies rated below investment grade, he added.
“Leveraged loans are at the top of my list and high-yield debt for anyone who doesn’t have cash flow,” he said.
Refinancing problems will have an outsized effect on market sentiment, he said, because investors have become too complacent to be bailed out by central banks with lower rates. This time, he predicted, Fed governors will stick to their anti-inflation mantra and keep rates higher.
“They don’t want to recreate what they did today. Any intervention they make to stabilize the markets will be significantly smaller [than previous efforts] and the market will be very disappointed,” Britton said. “The Fed and other central bankers will be incredibly shy.”
Indeed, Mary Daly, president of the Fed’s San Francisco branch, warned this week that it is too early to “declare victory” in the central bank’s fight against high inflation.
Britton said he doubts the Fed can prevent a recession, and that could push the U.S. unemployment rate to 4.5 percent from its current level of 3.5 percent.
“Ultimately, the Fed has an extraordinarily difficult job. That [the economy] it is a very large plane that they are trying to land on a very short and very narrow runway. They could stick the landing. I just think it’s going to be difficult.”
Additional reporting by Laurence Fletcher in London and Eric Platt in New York