Global Credit - Deja Vu all over again
Equity and credit markets have experienced a round-trip trade over 4Q18 and 1Q19.
In our previous piece published in 3Q18, we highlighted how geopolitics were likely to be the primary driver of volatility and return in the global corporate bond space given our benign assessment of micro credit conditions at that time. Curiously, as we sit here today approximately eight months later, we have reverted to that view despite the significant level of volatility experienced across global markets over that time frame.
Equity and credit markets have experienced a round-trip trade over 4Q18 and 1Q19. While valuations and technicals in the corporate space, and therefore our positioning, have fluctuated vigorously during this period, a key constant has been that company fundamentals have remained in relatively decent shape throughout. Remarkably, we find ourselves in the same circumstance again – positioning more defensively given our view that the available credit risk premium in the market does not compensate as much as we would prefer given the plethora of macro risks at present. Our previous top concern regarding withdrawal of liquidity by the major central banks around the world now appears to be in the rear-view mirror, but others, such as threats to global trade, Brexit, and Middle East uncertainty, remain front and centre. Encouragingly however, global investment grade corporate bonds are likely to fare better than other risk assets, such as equities or high yield corporates, during periods of elevated volatility.
In relatively short-order, markets have shifted from pricing in several rate hikes in the US to now pricing in one or more cuts over the next twelve months. The Fed’s dovish reaction to the 4Q18 weakness has most market participants believing that the rate hiking cycle is now complete. Whilst our house view is that market pricing for cuts is overly aggressive for an economy that is humming along, we do feel that there may only be one more hike, and not until the end of 2020. Either way, this development, coupled with simulative measures out of China and a supportive ECB and BOJ, is likely positive for corporate credit. The risk of liquidity withdrawal by the world’s major central banks, which was a chief reason for the selloff experienced during 4Q18, has effectively been taken off the table for the foreseeable future.
While dovish central banks are a welcome development for global markets, any worsening in the trade rift between the US and China would have the potential to spoil the party. One hand giveth, the other hand taketh away, as the idiom attests. Markets have barely been pricing in any risk associated with the US/China trade negotiations. Even the latest developments in May that witnessed the Trump administration increasing tariffs on $200billion of goods and threatening more, followed by Chinese retaliation, caused only a slight stir in equities and corporate credit. While our baseline view remains that some form of agreement will ultimately be reached, we do believe that it could become a protracted affair and that the probability of a negative scenario coming to fruition has increased markedly. With corporate bond valuations only slightly cheaper from where we were last September and an increased likelihood of higher volatility associated with this issue, among others, we felt the prudent move was to scale back risk positions until valuations better reflect this reality. The main obstacle to an agreement appears to be the US’ insistence that the protection of intellectual rights for US firms operating in China become codified into Chinese law, which may be a tough pill to swallow for President Xi.
While there is no shortage of other potential negative macro threats that could serve to upend global markets over a reasonable forecast horizon, the US’ aggressive stance with Iran, anemic growth across Europe, and the never-ending Brexit saga top our list of worries. The Trump administration appears determined to force Iranian oil exports to zero by not extending sanctions exemptions that allow certain countries to buy from Iran. This action is prone to further undermine an already weak economy and will likely lead to some form of response. It is possible Iran will choose to simply wait Trump out in the event that he loses in 2020, but more belligerent measures could include restarting its nuclear programme or closing the Straits of Hormuz. On the Brexit front, while we have received a bit of a reprieve for the time being, the Conservative Party seem to be losing support while Nigel Farage’s Brexit party has been making gains. As we move ever closer to the fall, this dynamic is likely to begin to be priced by markets.
While underlying corporate fundamentals remain in fairly stable shape, with idiosyncratic concerns limited, valuations have moved once again to the point that macro risks appear to be mis priced. We are currently anticipating a period of heightened macro and spread volatility which will help us to redeploy risks into oversold credits.
Scott Service, Vice President, Loomis Sayles, manager of the St. James’s Place Investment Grade Corporate Bond Fund
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