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3 things to watch in credit markets as volatility picks up

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      By Bill Hackney, Atlanta Capital Management

      Atlanta - I remain constructive on the outlook for the U.S. equity market despite the recent volatility. Still, it makes sense to think about what are the substantial risks facing the U.S. economy and stock market in the next couple years.

      A trade war? Political change that reverses the tax cuts and increases regulation? These are certainly legitimate risks that are top-of-mind for many investors.

      But the risk I fear the most is one that seems to be getting too little attention these days -- the implications of continued interest rate increases on a U.S. and world economy that remain heavily burdened with debt.

      My view is by the early months of 2020, interest rates will be high enough, say, 3.2 to 3.8% for fed funds and 3.8 to 4.8% for the 10-year Treasury note, to cause problems in the over-leveraged sectors of the world economy. As these problems manifest themselves, I would expect credit conditions to deteriorate and more of my market indicators to turn negative.

      Here are the three areas of the credit markets that investors should monitor closely:

      1. The U.S. corporate debt market. In their quest for attractive yields, many investors have plumbed the depths of the high yield bond market. Now is a good time to begin upgrading the quality of fixed income portfolios (as well as equity portfolios). Credit spreads (the gap between the yield on high quality and low quality debt) are still narrow by historic standards. This indicates credit conditions are easy and investors are confident that good economic times will continue. However, history shows that credit spreads can widen quickly at the first sign of economic trouble.

      2. Dollar-denominated emerging market debt. This market has been another source of attractive yields in a low rate world. Emerging market (EM) countries like China, Russia, Argentina, and Turkey (and the companies located there) have borrowed about $2.7 trillion in dollar-denominated debt which matures between now and 2025. This debt must be paid off or refinanced. However, the plunge in many EM currencies relative to the dollar coupled with higher U.S. interest rates will probably cause some borrowers to default in the years ahead. There's a potential crisis brewing.

      3. U.S. government debt. There's no credit risk here, of course. But this market is going to be critical to monitor because interest on the debt is set to skyrocket thanks to rising interest rates and chronic deficits as far as the eye can see. In the super low interest rate climate of the past, politicians and the public didn't really feel the sting of deficit spending. That's about to change. Interest on the federal debt is the fastest growing item in the federal budget. Now at 1.4% of GDP, it will exceed Medicaid spending in 2020 and defense spending by 2023. It will increasingly limit the government's ability to respond to a recession (i.e., increase deficit spending) and it may serve as a political rationale for unwinding part or all of the 2017 tax cuts. Expect to hear a lot about this during the 2020 Presidential campaign.

      In the past few days, the stock market sustained a nasty correction as frequently happens in October. Given the longevity of the bull market, it's natural for investors to fear this is the "beginning of the end." I believe the current turmoil is a brief correction brought on by a spike in interest rates and oil prices and the uncertainties created by the tariff wars and the mid-term elections.

      Bottom line: In my view, monetary conditions are not yet tight enough and inflation is not yet high enough to end the economic expansion and bull market in stocks. Those conditions are unlikely to occur before 2020. Granted, the market should begin to discount these problems ahead of time. So, Halloween 2019 could be pretty spooky.