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Fundamentals have deteriorated and credit valuations are not very appealing either. But that does not matter anymore. There is only one trade and that is the Central Bank. Although we would rather be underweight risk, this very strong technical support keeps us neutrally positioned.
The US economic cycle is slowly coming to an end. The economy is really only running on one engine and that is the consumer. And that engine is starting to sputter as well. Seven years into the expansion the odds are increasing of a US recession in 2017. It is therefore not surprising that the Fed is very hesitant to raise rates. At the same time the low rates are causing collateral damage in the form of heavily distorted financial markets. That leaves the Fed with little other option than a ‘hawkish hold’.
In Europe, economic growth is also losing momentum. A recession is much less likely in Europe than in the US though. We see late-cyclical signals in the US that we do not yet see in Europe. Corporate balance sheets have deteriorated in the US as companies have engaged in share buybacks in order to boost earnings per share (EPS) to offset declining profits. Corporates currently outspend their cash flow and as a result see debt levels increase. The high leverage makes credit markets more vulnerable when the economy runs into a recession.
Economic growth in emerging markets continues to decline in the aftermath of years of rapid credit expansion and the end of the commodity super cycle. Dispersion within emerging markets is large.
The fate of emerging markets (and developed markets for that matter) very much depends on how China will perform. China still delivers most of global GDP growth and we have seen its impact on commodity markets last year. Chinese growth has been supported by rapid credit expansion in the last years. It only takes credit growth to decelerate (it does not require credit contraction) for economic growth to suffer.
Even worse is that credit has been expanded in the least productive parts of the economy, state-owned enterprises. Banks have been ‘guided’ to extend credit to these parts of the economy. A bad debt problem is still looming.
With declining population growth in both developed and emerging markets in combination with declining productivity, it should not be a surprise that trend growth is structurally at a lower level now. For a long time this was offset by credit growth, but that is not sustainable. Central banks are trying to reflate the credit bubble. This is a risky strategy: not only can it destabilize markets, it also takes away the urgency for politicians to implement badly needed structural reforms.
Spreads are just marginally below long-term average levels for most credit categories, so we cannot say that the market is screamingly expensive. However, it is fair to say that spreads are low for this phase in the cycle with rising default rates, peak leverage and a slowing economy in the US.
When we compare emerging with developed spreads we conclude that the ratio has dropped below the average historical level. There is little premium to hold emerging versus developed credits. Certain markets have become outright expensive. Brazilian credits, for example, have largely mean-reverted towards pre-January levels while the reform path ahead is still full of risks.
The European Central Bank’s Corporate Sector Purchase Programme (CSPP) still provides a very strong technical for European investment grade credit, which is spilling over to high yield as well. The CSPP is so big that it dwarfs all other factors that could drive markets, including very negative events such as Brexit.
The big question is whether the market continues to have confidence that central bank policies remain supportive. Risk assets are very likely to react negatively to monetary tightening. A communication error is probably the biggest risk here. We start to see investors and economists increasingly questioning central bank credibility. A broader loss of confidence has the potential to seriously derail financial markets.
Financial markets have become deeply dysfunctional. They no longer seem to be pricing in fundamental risks (e.g. Brexit). It has become very much a circular market along the lines of “I buy when you buy”. People buy equity because companies buy back stock. Companies buy back stock because they have cheap funding from credit markets. Investors are buying into credit because the Central banks are flushing the market with liquidity. So in the end it all comes down to the same thing: do investors believe that other investors continue to have faith in an extension of easy money?
As central bank policy has become such a dominant driving force, correlations between asset categories have increased. When markets turn, there is nowhere to hide. Even the correlation between spreads and rates that always used to be negative has now turned positive. Investors have all crowded into the central bank trade as negative rates on cash make it too expensive to stay side-lined...
From a fundamental point of view we would rather be underweight risk at this stage but we realize that this central bank policy can last for a while. So we keep most credit portfolios neutrally positioned in terms of beta, scrutinizing individual credits for vulnerabilities to an economic slowdown. On a global basis we still have a preference for euro credit over dollar credit. We stick to our defensive positioning in emerging market debt, but try to keep the beta not too far below 1. Central banks are a key driver of these markets as well.
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