Investing is not about making a point forecast. Rather, our view is that it entails assessing the probability of various scenarios and determining what’s been discounted by markets. This is especially relevant as we present our latest quarterly outlook, says Sander Bus, Co-head of the Robeco Credit team. “We agree with the consensus forecast of strong economic growth – but not with the view that a long position in credit is always justified under these conditions.”
It seems obvious that the global economy will in 2021 experience its strongest growth in decades. Ultra-loose monetary policy, aggressive fiscal stimulus and the unleashing of pent-up demand as the economy eventually reopens fully, are expected to pave the way for high single-digit economic growth. Some forecasters even suggest that the US could experience double-digit nominal GDP growth.
The Fed and the ECB have made it very clear that they will keep rates low for a long time. The Fed has signaled that it will deliberately be behind the curve, and that it will accept higher bond yields as long as these are driven by higher inflation expectations.
Today’s fiscal and monetary policies are unprecedented. In fact, one could argue that they are a giant dual experiment. When you are experimenting, unexpected outcomes are always a possibility.
Credit markets traditionally perform well in the first year after a recession. What’s more, spreads have been negatively correlated with rates most of the time in the last two decades. “So, why are we advocating a defensive positioning? The short answer is that the market is priced for perfection, which means that you don’t get paid for potential tail risks,” says Bus.
“While it’s possible that credits could keep rallying, the margin for error is extremely limited. The opportunity costs of being defensive are therefore low. We believe it very likely that better entry points to increase credit risk will arise in the next six months.”
With an expected acceleration in the roll-out of vaccines in Q2, the prospects of a full economic reopening are improving rapidly – starting in the US and followed by the UK and Europe. On top of that, base effects will result in spectacular year-on-year GDP growth. The OECD is now forecasting that developed markets will have recovered most of their economic losses by the fourth quarter of this year. In its latest projections, US GDP growth will even outpace the pre-pandemic growth trajectory.
The health crisis triggered a powerful fiscal solution of an unimaginable scale, and we have probably not seen the end of it yet. A new infrastructure bill is already in the making in the US. The projected fiscal stimulus for 2021 is up on 2020, despite last year’s two large programs. Fiscal stimulus in Europe, albeit not as outrageous as in the US, is set to continue for at least another year. This is very different compared to the aftermath of the global financial crisis, when fiscal austerity dampened the recovery.
Victor Verberk, Co-head of the Robeco Credit team, says: “We think that the market is too relaxed about higher rates. Higher nominal rates are not a problem as long as inflation rises at the same pace and hence real yields stay low. But as soon as real yields rise, we expect it will start to bite. Even though we subscribe to the view that most central banks would prefer to keep real yields low, this is not fully in their control. With the US economy set to steam ahead, the Fed will probably start discussing tapering at some point from this quarter onwards. That could trigger a further increase in real yields, either through rising nominal yields or a drop in inflation break-evens”.
“All in all, we are concerned that markets are ahead of fundamentals. Should there be any unexpected combination of negative surprises on rates volatility, policy errors or geo-political tensions, conditions could turn more bearish.”
An improving macroeconomy and the absence of monetary tightening usually are great for risky assets. But, says Bus, “these factors are so clear that they are widely recognized. And credit markets played the full recovery in 2020. In a normal economic recovery, spreads usually start at much higher levels as there is always doubt in the early days about the sustainability of the recovery. Remember people talking about green shoots? This time the slump was the result of a pandemic and the solution was colossal policy support, followed by a vaccine. We are therefore at a place of such broad agreement about the recovery that it has been fully priced in even before it has started. That explains the massive bull market in the midst of the worst recession ever.”
Generally speaking, credit markets are back to or better than pre-pandemic levels. All categories are well below the bottom quartile spread levels, with some even approaching their all-time tights. The best environment for carry is usually the boring periods with modest economic growth and inflation. Recessions are the worst, while periods of very high growth are also undesirable, due to the unleashing of animal spirits, risk taking and exuberance on the corporate leverage side, and the risk of extreme swings in policy and interest rates to cool any resultant overheating.
On a relative basis, there are two pockets of the market that still offer some value: financials and emerging market corporates. These are also tight versus their median spread, but less so than the other categories. Financials are also the least duration-sensitive sector as both insurance as well as banks can benefit from higher inflation and steeper rates curves. For emerging markets, sector and country selection remain key, with commodity-related names benefiting from reflation in the near-term, while commodity importers suffer.
All considered, the starting point for valuations for the coming period gives us a sense of unease. There is very little room for error.
Bus believes there is still a good chance that this will be a boring year, in which the fireworks are in treasuries and growth equity markets, while credits just deliver their carry with spread remaining range bound at current low levels.
“Still, we think that it is better to be positioned on the cautious side. ‘All signs on green’ has become the widely shared view for credit. Even some of the perma bears on the sell side have now turned bullish. Yet, the market no longer compensates for tail risks. The consensus long makes the market vulnerable to negative surprises – be it policy errors, Covid setbacks or geo-political tensions.”
We are not running huge underweight betas. We are positioned just below one by focusing on the higher-quality names in the universe. Given the very low dispersion in markets, it does not pay to reach out for the riskier names. Our positioning is consistent for all credit categories.
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