Although fundamentals are positive with a global economy firing on all cylinders, risky assets are expensive. Technical factors are not helping either: towards the end of this year, central banks will be leaving a void which will be virtually impossible for private investors to fill. Our positioning is cautious but active.
Still, there’s no reason to panic either. In fact, this is when active managers come to life. With the Fed in Quantitative Tightening (QT) mode, and the ECB about to taper its Corporate Sector Purchase Programme (CSPP), volatility is set to increase. This will cause higher dispersion in our universe and this offers opportunities for issuer selection.
Within a global context, we have a clear preference for Europe, where high yield offers extra carry and investment grade companies tend to be more conservative than in the US. We also like financials, believing that insurance companies and banks can be a hedge in an environment of rising interest rates.
There are several indicators that the cycle is maturing. It is hard to predict the exact turn of the cycle and markets can stay in ‘peakish’ periods for quite a while. We believe that US markets are leading and have drawn their dot just behind the peak of the bull market.
In our outlook, we always look at three factors: fundamentals, valuations and technicals.
Fundamentals are still favorable for credits. Global growth is driven by three locomotives: the US, Europe and China. Whereas the former two show synchronized growth, growth in China is moderating but still high.
How long will the US economic cycle last? True, fiscal stimulus may extend it a little, but at the same time it will only aggravate the imbalances and ultimately deepen a potential recession. Inflation is still very much subdued, but all ingredients for higher inflation are already there. Labor markets are tight. The labor force is shrinking due to the withdrawal of baby boomers, making labor scarce and thus more expensive. Other ingredients are the US twin deficit and increasing protectionism.
US corporate leverage is unsustainably high. European growth is solid, with broad participation of the entire euro area. Risks are certainly not coming from Europe, but if the US were to slow down, Europe will not be immune.
For emerging markets, it is important to watch the dollar. The market is very relaxed in expecting further dollar weakness. It is easy to see why the dollar would drop further, given the ballooning twin deficit. However, if this does not happen, emerging debt could be seriously at risk. Foreign borrowers have used the dollar market for funding. When dollar depreciates it helps their balance sheets, but dollar strength would do exactly the opposite.
No matter which way you look at it, credit markets are expensive in all rating categories, both in Europe and in the US. We still prefer Europe, though. For European high yield, we still get some extra spread compared with similarly rated US high yield companies. For investment grade, spreads are pretty similar, but European companies tend to be more conservative.
Within Europe we still see some value in financials. Insurance bonds should provide some sort of hedge against rising rates, as their profitability tends to increase when interest rates rise. The same goes for banks, which benefit from falling levels of Non-Performing Loans and stronger balance sheets.
We have extensively discussed the LIBOR-OIS spread widening. This spread reflects the difference between the risk free central bank rate and the rate banks pay in the interbank market. It is considered a measure of health in the banking system. A wider spread means that it is more expensive to borrow dollars. This makes hedging dollar risk more expensive for foreign investors, which could lower their appetite for US fixed income assets or even cause them to sell out of them.
Global central banks are still a key factor to watch. Although the European Central Bank and the Bank of Japan are still buying more than what the Fed is shrinking, expansion will turn into reduction by the end of 2018.
We have seen a dramatic increase in capital market funding by corporates, shifting away from bank lending. As capital markets tend to respond faster to a changing environment than loan officers, credit conditions for corporates could tighten much faster than has historically been the case.
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