The US economy is still firing on all cylinders. The Fed is continuing to hike and the resulting tighter dollar liquidity is putting pressure on some emerging markets, while in Europe the ECB is reluctant to tighten more aggressively as political risk is overshadowing economic fundamentals. Co-heads of the Credit team Victor Verberk and Sander Bus do not think the negative correlation between the US and international credit markets can continue indefinitely.
This divergence is reflected in global bond market performance in the last three months with US spreads tightening, while Europe and especially emerging markets have underperformed. “We reaffirm our belief – made in our last outlook for Q3 – that the tightest spreads in this cycle are behind us”, says Bus. “And although there is no reason to expect a full-blown crash anytime soon, spreads are likely to widen gradually.”
Verberk goes on to highlight the importance that weak market technicals are playing in the current environment. “The fact that the Fed is on a hiking path and the ECB’s quantitative easing is drawing to a close are not helping fixed income as an asset class. The increased US Treasury issuance to finance President Trump’s fiscal deficit could crowd out other financial assets and US investment grade credit is right in the line of fire.”
The US economy is growing well above potential, job openings exceed the number of unemployed workers and consumer sentiment indices are strong. Although inflation remains muted – core CPI ex-shelter is still at just 1.3% – wages are definitely rising. “Nor should we overlook the extent to which inflation is a lagging variable: it could be with us before we are fully aware of it,” says Verberk. “Leverage is higher as a result of M&A-related debt issuance and although headwinds in the form of tighter margins and higher input costs will increase, a corporate crisis does not seem to be a major risk as earnings continue to grow at a healthy pace.”
In Europe, Italy remains a cause for concern and it could have a significant destabilizing effect, especially on the peripheral markets. “Business sentiment in Europe is still positive, but industrial production has come down,” explains Bus. “And although inflation could trend higher from its current range-bound levels on the back of higher wages, the ECB is not under huge pressure to hike rates too quickly or aggressively.”
Emerging markets that depend on foreign funding, like Turkey and Argentina are feeling the pain of the dollar squeeze. Some have been forced to hike rates to shore up their weakening currencies. “If this trend continues it could lead to a severe economic downturn,” acknowledges Verberk. “Demand in China is weakening. Lower infrastructure spending is evident in the falling demand for industrial metals. The Chinese authorities have limited policy options left to stimulate the economy and may have to fall back on fiscal stimulus in the form of tax cuts.”
While the market in Europe is not cheap, there are some relative comparisons that are worth noting. If you divide US IG spreads by European IG spreads, the ratio has dropped from 1.7 to 1.0 since the start of the year and the story is similar in the high yield space. “In the case of high yield, it’s important to realize that it’s not just a case of a better spread in Europe; the quality of debt is much better too,” explains Bus. “Current US CCC credit spreads do not offer sufficient compensation for a average default scenario.”
As far as emerging markets are concerned, we are not convinced the worst is behind us. “Spreads are still not wide enough across the board, but we are prepared to take positions in bonds that have repriced to more attractive levels in the recent turmoil.”
‘US credit has continued to outperform and is now outright expensive’
“Reduced central bank liquidity is still a clear driver for markets,” says Verberk. Higher US rates are affecting US dollar reserves and causing the first cracks to appear in the offshore dollar market. “In the US, credits are facing increased competition from the new issue Treasury market, for example, while European IG spreads have already widened significantly in anticipation of the end of the ECB’s bond buying programs.”
Another interesting technical development is the massive growth of the BBB universe. This market has more than tripled in Europe and more than doubled in the US. “If the tide turns in the market and rating agencies are forced to act, the relatively small high yield market could be inundated with a wave of ‘fallen angels’ as companies lose their IG status,” explains Bus. “But given the still solid outlook for corporate profitability, this is not a major worry in the short run.”
“Valuations have become slightly better in Europe and emerging markets, but not enough to justify a more aggressive positioning,” says Verberk. “The new era of tighter monetary policy means we are probably going to see more instances of aggressive de-risking in pockets of the market. We also still see value in financials, although we are selective in terms of the issuers in which we invest and prefer the more senior parts of the capital structure.”
“Tighter global monetary policy, diverging growth patterns in the major economic regions, shrinking dollar liquidity and increasing competition from US Treasuries could crowd out credit,” admits Bus. “But, in general, fundamentals remain solid, especially for corporates and a scenario of gradually rising spreads offers opportunities for us to find value in those pockets of the market that reprice to more attractive levels.”
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