It’s right to be cautious in credit markets at the moment. Spreads are widening in response to how the deterioration in macro fundamentals (slower growth expectations and higher interest rates) impacts on company balance sheets and how investors assess credit risk. There is no end of negative individual credit stories in both the high grade and high yield parts of the market. With Brexit, trade, Italy, a Chinese slowdown, and lower oil prices remaining on the macro agenda, it’s difficult to see the process of spread widening stopping just yet. However, what this means is that value is coming back to the bond markets. This is obvious in the US dollar denominated sectors if considerably less so in Europe. After underperforming in 2018, US dollar bonds should race ahead next year.
Wow. What a time to be alive. Having recently hit the age at which, thanks to George Osborne’s pension reforms, I could actually start tapping into my pension savings, the markets are making me want to work for ever. From Trump’s tweets to Brexit to the Italian budget there are so many potential triggers for volatility. Everywhere you look there are reasons to ask the question – is that now cheap enough to be a good investment? General Electric bonds have dumped, there is a scandal in the Nissan-Renault relationship and number of bond issuers in the European high yield market are trading at truly distressed levels. It is very hard to see where the safe havens are with the US Treasury market still staring more Fed rate hikes in the face, UK gilts staring a hard Brexit in the face and German bunds being so expensive that things would really have to get bad for them to offer the safe-have correlation that investors in credit and equities look to bond markets to provide. These are crazy and distressing times for bond investors who look to the market for safety and income. How can a major global company like General Electric, a major bond issuer with a single-A rating, suddenly become the most unloved bond issuer in the market? The problem is that that the GE story is not alone.
Equity investors say they are focused on long-term earnings growth but the volatility of equity prices is clearly linked to quarter to quarter earnings reports. When equity volatility increases because of poor quarterly results, bonds get hit too. The sum of this is a widening of credit spreads at the market level and an increased dispersion of spread changes as investors distinguish between good and bad credits. I looked earlier this week at what had happened in the sterling credit market so far in November. Some bonds had seen their spreads against government bonds widen by over 200 basis points (bps). For longer maturity bonds that represents a significant hit to price and a drag on performance in portfolios that hold those assets. Of course, that is an extreme but credit markets have seen a generic and significant widening of spreads since October. For individual issuers there is always a specific story – poor earnings reports, corporate controversy, refinancing issues – but when we sum them up there starts to be a macro story as well. Given where we are in the economic cycle and given the increase in funding costs, especially in the US, it’s safe to say we are in something of a credit bear market.
But better value
For many credit markets the extra spread that investors receive relative to a government bond benchmark is currently at the highest levels since early 2016. In actual yield terms the comparisons are more interesting, especially in US dollar based markets. Investment grade indices in the US now have a yield-to-worst of 4.5%, something not seen since 2010. This is the case for investment grade debt in the US and in dollar denominated emerging market sovereigns. Yields in sub-investment grade markets were higher in 2015 but even here the market is trading with more attractive valuations than for most of the post-crisis period. It could get worse before it gets better but even today the entry point for credit is better than it has been for some time, an important consideration for investors with new money to invest or those with allocations out of equity markets.
The post-QE road map
The move in rates and credit markets has been in line with my expectations for this year, especially in the US dollar markets. The increase in rates generated by the Federal Reserve’s (Fed) interest rate policy has tightened liquidity conditions and has raised financing costs. While the macro-economic data has continued to be quite strong, there are signs that growth is coming off the boil a little in the US. More importantly, the end of QE and the normalisation of interest rates has highlighted valuation issues in credit. The less positive macro environment (slower growth and higher rates) is impact on the micro environment, especially when businesses are coming off peak earnings or are highly leveraged. This widening of spreads amid a deteriorating fundamental backdrop (still positive on the whole but not getting better) will create opportunities for bond investors. In my review of the sterling credit market that I mention above, I observed a number of bonds yielding well above 4.5%. One could be tempted to blame concerns about Brexit but the reality is that credit has underperformed everywhere (and the ten worst performing issues in the UK market in November have all been bonds issued by GE). The process of price adjustment may not be over yet. The Fed is still expected to raise interest rates in 2019, global growth may re-synchronise but at a much lower pace next year, and there remain plenty of risk factors (trade, Italy, Brexit, and the recent sharp fall in the price of crude oil). This is not to mention some negative technical factors on credit such as the growth in the share of BBB-rated issues in most investment grade markets and the end of the European Central Bank’s bond buying programme. In the high yield markets analysts have not really revised up their default expectations yet and, if they do, this could introduce even more of a risk premium into those sectors.
The end of QE and the beginning of the process of reducing the size of the Federal Reserve’s balance sheet has shifted the investment environment. Liquidity has tightened in the dollar area and there have been a succession of victims – emerging markets, equities and now credit. We are in the phase of global adjustment that many predicted would be seen once global central bank balance sheet growth stopped. I said a long time ago that risk-free assets would be the relative beneficiary of the monetary policy normalisation process because risk assets were the beneficiary of QE. Investors were crowded out of low yielding safe assets into higher yielding risky investments. Now the reverse is happening. The problem is that it is happening with fiscal expansion in the US and with higher interest rates so even if Treasuries are the safe haven bet, they haven’t fully protected capital this year because of their own valuation adjustment to the new monetary environment. Europe has this process to look forward to at some point.
Roll on 2019
As we look towards next year the prospects for returns in US dollar fixed income are better than they have been for some time. The Fed is probably more than half way through the tightening cycle and the carry from US fixed income is already much higher as a result of higher rates and the widening of spreads. Moreover, if the economic cycle does start to roll over the rates component of a credit portfolio should perform positively, even if credit spreads do widen. On today’s pricing it would need another 20bps of widening in US investment grade credit for a long credit position to underperform rates on a relative basis. However, looking at the overall yield it would need to increase by more than 65 bps to deliver a negative outright return. The higher the entry point for bonds, in terms of yield, then the higher the yield increase needs to be to deliver higher returns. So while credit might be in a bit of a relative bear market, overall fixed income is coming to the end of its bear market. It has not been quite the bear market that many expected, given the absence of strong upward pressure on inflation, which could mean that investors might not be tempted back into the bond market quickly. For anyone that is relatively optimistic that the US will avoid a really nasty slowdown and that inflation will generally remain well behaved, then the time is getting closer to add to bonds. This is a story mostly for the US dollar denominated markets.
Europe still waiting for Godot
It’s hard to generate the same enthusiasm for Europe. Either the European economy does better and the ECB is able to deliver the beginning of its monetary policy normalisation, or growth slows further thus preventing the ECB from moving at all. Either way it is hard to generate positive returns from fixed income given the starting point. My guess is that the growth and inflation outlook will prevent the ECB from doing anything more aggressive than ending-QE and taking the deposit rate back to zero, but even under that scenario, fixed income investors need to rely on sovereign and corporate spreads narrowing somewhat to generate overall performance. With the Italian saga likely to continue into next year and with Brexit potentially disrupting some sectors, it is hard to be optimistic on spreads just now.
A Night in December
Hopefully we will have more to say on Brexit next week given the likelihood of the meaningful vote being held in parliament soon. This will be an important moment as it will be a major marker in the ongoing political drama in the UK. Not that things will necessarily be clearer but from my point of view the odds of Theresa May’s deal being the blueprint for the future have shortened while the odds on a hard Brexit have lengthened. This doesn’t mean she will be successful in getting her way on her big night in December. Interestingly, the betting on either remaining or holding a second referendum has become more interesting too. There are numerous political permutations for the UK in the weeks ahead – including a potential leadership challenge in the Conservative Party, a vote of no-confidence in the government should the Withdrawal Agreement be rejected, and even a general election or a second referendum. We should also get the Treasury’s impact assessments under various Brexit scenarios being published. If, as many think, they will say that all outcomes are worse than remaining in the EU, the support for staying in might get a further boost. Yet it remains politically difficult to go against the results of the June 2016 vote. All these uncertainties will stay front of mind for some time. Markets are hoping for some certainty and an outcome that keeps the UK as close as possible to the EU in terms of economic relationships and is the least disruptive in terms of business. Anything short of that and we will likely see much weaker UK equities, credit and currency.
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