Over-Leveraged Companies Pose Recession Risk, Aberdeen Warns

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(Bloomberg) -- The continuing economic expansion and pending benefit from U.S. tax cuts offer a crucial window for companies to reduce leverage and get ready for the next downturn, according to $808 billion asset manager Aberdeen Standard Investments.

“There is too much U.S. corporate debt to cope with a U.S. recession,” Craig MacDonald, the firm’s global head of fixed income, said in a telephone interview from Melbourne, while noting that he still sees a “relatively strong” global economy. “It’s very important that this deleveraging occurs, as over-levered corporates pose a tail risk to markets,” he said.

Ballooning company debt is unnerving investors as short-term borrowing costs rise, concerns of a trade war persist and central banks move to take back unprecedented liquidity. Guggenheim Partners reckons the next recession will originate in the highly leveraged corporate sector.

The other two “tail risks” Aberdeen is focusing on are mercantile tensions escalating into a fully fledged trade war, and an inflation shock that sends global interest rates spiraling higher, MacDonald said.

The following are excerpts from a Q&A with MacDonald.

1. Will a U.S. and China trade war happen?

Our base case is there won’t be an all-out trade war, but it’s not something you can just dismiss.

This will continue to have an impact in terms of volatility.

2. How are you hedging your portfolio amid rising risks?

If it’s an all-out war in a risk-off environment, you do want to be short duration. If you look at credit, we’re not particularly exposed to Chinese companies. We’re very underweight commodity names other than oil and gas, and then you probably don’t want too much pure beta -- the really risky CCCs, the really risky emerging market names.

3. Will rising short-term funding costs ease anytime soon?

I wouldn’t say in the very near future. Interest rates are going up -- Libor quicker than other rates because of some of the technical issues around the repatriation of dollar debt and large short-term funding needs. That’s a technical issue that will take time to resolve. The most important thing is it doesn’t signal a real problem in the banking system.

4. Where do you see 10-year U.S. Treasury yields heading?

We certainly think in and around 3 percent is a reasonable level, but that could be 3.2, 3.25, it could be 2.8 percent. We don’t see a massive breakout in our base case because we don’t see a massive breakout in inflation. If you look at the curve, we think it’s not predicting recession right now. We prefer credit to government bonds, we still think that has some legs as long as you’re careful, but our base case is not a bloodbath in government bonds over the next year.

5. What is your view on Australian government bonds?

We think most of the gains have gone now. We’ve reduced our overweight, but are certainly not underweight. We don’t expect interest rates to go up any time soon.

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