The global economy is strong. Output gaps are closing with the economy growing above its potential. This means that further growth could result in accelerating inflation and central banks will have to respond. The end of monetary easing has arrived with the Fed in a rate hike cycle, the European Central Bank (ECB) being expected to start tapering Quantitative Easing (QE) and the People’s Bank of China (PBOC) tightening monetary conditions as well.
Growth in itself is good for credit, but the credit cycle is mature, especially in the US. Credit spreads offer only limited room for further tightening, especially when we consider that corporate credit quality keeps deteriorating, particularly in the US and China. Wage growth and higher rates can put pressure on profits.
Volatility has been subdued for a pretty long time due to the predictability of central banks. This has also reduced the dispersion in markets, which made it more difficult for active management to make a difference. With monetary conditions now tightening we should expect more dispersion and less predictable correlations. That is good news for active managers like ourselves.
On balance, spreads have tightened in all credit categories over the last three months. Valuations have therefore become more expensive. In the past, we have seen that credit markets can trade at very tight levels for an extended period of time and then suddenly widen aggressively. It is always very difficult to exactly time that moment, but it is fair to say that many parts of the market are more or less priced for perfection and there is limited room for error. That means that we do no longer pursue a strategy of buying on dips. That would be too risky as the end of the credit cycle is nearing.
We remain conservatively positioned with a preference for Europe, and within Europe a preference for financials. Even after the recent outperformance, we still believe that insurance companies trade too cheap and expect a bit more recovery from financials versus corporates in general. We are most cautious on emerging debt and US high yield. Within high yield, we stick to our underweight in the lowest credit quality.
Monetary policy has turned into a negative technical for credit markets. Although the aggregate size of central bank balance sheets is still rising due to the buying programs of the ECB and the Bank of Japan (BOJ), momentum has certainly shifted.
Fiscal stimulus is not what is needed at this point in the cycle, but it is exactly what Donald Trump is planning to do. The Fed will respond and rates have much more room to rise. Economic growth is positive for credit, but the strong technical will disappear when the ECB reduces its QE program.
What we see as a risk are investors that have developed a high appetite for risk due to the perceived low volatility. Risk models that use implied volatility or current spreads as an input are typically pro-cyclical in nature. When markets turn, risks go up and investors might be forced out of their risky positions. We have seen huge flows into credit mutual funds over recent years, often from investors that can be classified as tourists. Low rates have pushed these investors out of money markets into higher yielding, higher risk categories.
We remain cautiously positioned with betas close to or just below 1 and focus on issuer selection. In the past years, we have always advocated to add risk on weakness as we knew that the strong technical on the back of central bank buying was supporting the markets. That has changed now and as a result we have become less courageous.
In emerging debt, we nurture our short beta position and quality bias. we are approaching the moment at which less monetary stimulus will also affect emerging credit markets.
We prefer financials and more domestic consumer-related sectors. We are hesitant to invest in companies with a high exposure to global trade or the capital spending cycle.
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