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The quarterly outlook for credits: dot plots and tantrums

25-06-2015 | UK | Insight | Sander Bus, Victor Verberk In our latest Credit Quarterly Outlook, we note two changes that are taking place in the credit markets. First, the US credit cycle is becoming unfriendly. Corporate releveraging is accelerating and margins have peaked. Second, the financial repression of policy makers is now increasing market volatility in many asset classes. The market place is obsessively watching dot plots and suffers from tantrums as a consequence. Add the summer illiquidity and we conclude we are up for a less friendly period in this business cycle (for many asset classes).

Speed read
  • Financial markets are entering a new phase in the aftermath of the debt supercycle
  • Financial repression by central banks cannot prevent increased volatility as the credit cycle is aging and positions are crowded
  • The sweet times of easy and nice return on financial assets are over

US growth is expected to remain at a subdued pace of 2%. The economic cycle in Europe is lagging the US cycle as usual. Growth in Europe improves, from a low base, admittedly, but it helps to improve the inflation outlook a bit. In emerging markets we see further conversion in growth rates with developed markets. All of these economies have to a different extent one thing in common. There is lack of aggregate demand and indigestion of debt. Policy makers around the world choose the same solution; printing money. The US might start to reverse this soon but we are not convinced it will be a smooth transition.

A new part of the business cycle
In the last few quarterly outlook sessions we wrote about herding, investors acting like sheep and warned about complacency. Obviously one can never forecast turns in market cycles or even economic cycles. Only after many months does one realize the cycle has turned in terms of earnings, GDP or credit spreads. We discussed the simple fact that often after seven good years a bad year comes, just because that tends to happen. That does not sound very academic but earnings cycles do exist. We show that after years of normalization in the housing market, car industry and even capital expenditures to a certain extent, it is not strange to prepare for a US recession in the next two years. What would that do with investor behavior after years of great returns?

We regularly wrote about this herding behavior before since we try to understand capital flows and the reason for investors to do what they do. We always worry about consensus positioning of market participants since we believe being contrarian is best in the long term. However this will become much more important. Monetary liquidity has increased and the search for yield has been pushing up corporate bond prices and stock market valuations, thus in general causing asset price inflation. This has caused investors to herd and flows will become even more important to understand.

Animal spirits
Two things have changed. First, US corporates really show animal spirits now. In other words corporate America is releveraging. Based on an ocean of almost free money, share buybacks, dividend deals and debt-fueled M&A are at cyclical peak levels. If one adds a chance that the earnings cycle is rolling over, corporate leverage is looking stretched. On top of that the Fed is slowly moving into a tightening phase. At a measured pace or not, the whole worldwide financial market is on steroids (monetary stimulus). What would that do to investor behavior?

Second, the excessive financial repression caused a new phenomenon; negative yields. This exacerbated the search for yield but also herd behavior. It is the explanation for increased volatility on FX markets, bond markets and stock markets. We are all excessively watching the Fed dots and whenever we fear changes (or dots up) we enter a tantrum causing one-way selling in an ever more illiquid market. By the way policy makers have changed and adapted their forecasts for growth and inflation so many times, one can wonder why the market has so much faith in them.

So, with US corporate behavior becoming typically late-cyclical and financial repression entering a phase in which it actually cannot prevent volatility anymore, we are changing the way we are looking at markets. A separate topic is that the economic cycle is aging too and recessions are still a normal phenomenon. From now on one will probably see a much more neutral positioning in terms of beta.

We remain positioned in the first quartile of our beta budget. However, regularly we will see a completely neutral beta. For emerging markets we make an exception. We strive for a neutral beta but our more strict underwriting criteria will probably cause us to end up with an underweight position. The main reason for not being underweight is the fact that markets have repriced a bit wider and there simply is not enough tangible evidence for defaults or recessions in the time horizon of the quarterly outlook.
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