GM Tests Tolerance for Riskier Assets

Its warning could change the generous attitude toward high-yield and emerging markets' bonds.
By Tony Crescenzi ,

The

negative news from

General Motors

(GM) - Get Report

is testing the durability of the sponsorship that investors have shown for risk assets such as high-yield bonds and emerging markets bonds over the past 2 1/2 years. The crux of this test is whether investors are feeling threatened enough by the continuing interest rate increases implemented by the

Federal Reserve

to alter their investment approach. Investors must decide: Are GM's woes company-specific, or do other companies share in the problems hurting GM, thus making it a market problem?

Fed's Actions Threaten Riskier Assets

The threat from the Fed's actions is multi-pronged:

1. The interest rate hikes might crimp the growth of liquidity in the financial system. That reduces the amount of money available for investing in risk assets, especially when compared with the past few years, when the Federal Reserve pumped enormous sums of money into the system.

2. The hikes are raising the risk-free interest rate, worsening the risk/reward relationship of owning riskier assets. For example, the six-month T-bill rate is now 3.08% and could be headed toward 4%, a marked change from a year ago when the rate was as low as 0.95%.

3. The hikes could slow the U.S. economy and thereby reduce cash flows to U.S. corporations, hurting the ability to repay debts. At the end of the day, a bond investor is most concerned with getting his or her money back. Weaker economic activity reduces the chances of that.

4. The hikes are causing a flattening of the Treasury yield curve. This affects the amount of positive carry, the rate of return that can be earned over and above the cost of borrowing money. It's reducing what can be earned by borrowing with short-term funds and reinvesting in longer maturities and in risk assets such as high-yield and emerging markets bonds. If the motivation for the carry trade evaporates, investors who bought securities with borrowed money might exit such strategies and thus spark a widening of credit spreads.

5. The hikes could reduce the appeal of U.S. fixed-income securities in the eyes of foreign investors, as these investors might fear capital losses. Foreign investors have been massive buyers of U.S. corporate bonds in recent years, having purchased a net of close to $300 billion of corporate bonds in 2004. Investors should thus pay close attention to the performance of the U.S. dollar, which could either spark selling in U.S. corporate bonds (if the dollar were to fall), or signal a potentially sharp widening of U.S. credit spreads (if the dollar falls it might be because foreign investors are selling U.S. corporate bonds).

These threats provide ample reason to believe that risk assets will not perform nearly as well in the upcoming months and quarters as they have over the past few years.

What's Good for GM ...

In 1955, GM had become so powerful a corporation that the U.S. Senate called upon GM's president Charlie Wilson to testify. In that testimony, Wilson famously said, "What's good for General Motors is good for America." In this context, is what is bad for GM bad for America? The near-term performance of risk assets thus depends to a very large extent on the degree to which investors see GM's problems as its own and not an extension of factors that could impact companies in the broader economy.

The bearish angle would include:

1. GM's problems are rooted in part in its lack of pricing power. This is a problem shared by many companies in many industries.

2. GM's problems have been worsened by the recent surge in commodity costs, a widespread problem in the manufacturing industry.

3. GM's labor costs have increased at a faster pace now that productivity rates are slowing from elevated levels. Non-farm productivity grew at a 4.1% pace in the U.S. from 2001 through the first half of 2004. Since then, productivity has advanced at a 1.7% pace, owing to gains in payroll employment (the amount of goods and services produced per worker tends to decline when employment levels increases). Many of GM's labor woes are unique to GM, however.

Emerging Markets Battered in Recent Days

The sharp weakening in GM's bonds might accelerate the weakness seen in recent days in the emerging bond markets. Note, for example, that the yield on Brazil's 10-year note has increased sharply to about 8.5% from 7.7% a little more than a week ago. The bloom may be off the rose when it comes to these markets for some investors who have been drawn to them by the reflationary efforts of the world's central banks. The situation is changing, however, as the Fed's interest rate hikes gradually are absorbing the very liquidity that powered the corporate bond market (and commodity prices).

Risk assets have had enormous sponsorship over the past 2 1/2 years, and the rates of return have been substantial. The justification for owning risk assets has been solid: Cash flow has been very strong and default rates have plunged to unusually low levels. The GM news may or may not be the news that tips the scale for risk assets, but the Fed's rate hikes are sowing the seeds for an eventual reversal or at best, sub-par returns relative to recent years.

The importance of the GM news surrounds whether or not it will prove to be the catalyst for a change in risk attitudes. An increase in risk aversion seems inevitable at some point, owing to the Fed's interest rate increases and the rise in the risk-free rate. Therefore, it will be critical to see whether investors treat the GM news as a sign of what is to come in the broader markets or as a company-specific problem of no threat to the rosy environment seen in risk assets over the past few years.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of

The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. He appreciates your feedback and invites you to send it to

tcrescenzi@thestreet.com.

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