The quarterly outlook for credits: Spectacularly wrong

The quarterly outlook for credits: Spectacularly wrong

06-01-2017 | 四半期アウトルック

Trump’s election will lengthen the business cycle, overheat the US economy and might trigger more Fed rate hikes. Corporate credit quality keeps deteriorating. Still, we need a bigger shock than Trump to derail global credit markets. The Fed might do it in the medium term. We remain positioned close to a neutral beta while trading the ranges in the short term.

  • Sander  Bus
    Sander
    Bus
    CFA, Managing Director, Co-head Credit team, Portfolio Manager and Head High Yield
  • Victor  Verberk
    Victor
    Verberk
    Deputy Head of Investments

Speed read

  • Trump’s election is likely to extend this business cycle: fiscal stimulus risks overheating
  • Much of this stimulus has been priced in
  • The end of ever more monetary stimulus is probably nearing...

Since the Great Recession, many investors, central banks and economists have been spectacularly wrong in their estimations of economic recovery. Recovery has been disappointing. Now, after all these years, we are approaching full employment levels (both in the US and increasingly in Europe). We see signs of recovery in sectors such as energy, causing some optimism for economic growth. US household income and spending are strengthening.

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A tail risk of more monetary tightening than expected

If Trump executes at least part of his program, this will extend the business cycle with one or two years, allowing imbalances to grow even further. If this happens, the Fed might have to go back to its dot plots of a while back. If the ECB sees data confirming that the European economy keeps strengthening as well, somewhere in the summer the ECB might taper even further, pushing pressure on all trends we saw over the past five years, such as lower yields and higher equity prices. The tail risk of higher yields and more monetary tightening than the market is pricing in, is increasing. Everyone might be spectacularly wrong again and underestimating the hiking cycle!

Of course nobody knows for sure what will happen and we can easily end up in another year of a search for yield and endless monetary stimulus. Something that has changed versus last quarter though, is that we see a small recovery in US profitability. This somewhat undermines the profit recession we talked about last time. What still stands is a meagre 0.5% productivity growth and accelerating wage growth causing pressures on margins.

The longer a business cycle lasts, the bigger the imbalances become. Corporate credit quality keeps deteriorating, especially in the US and China. It is not rare to see a big US corporate issuing cheaply in euros to fund M&A activities in the US, financed by the ECB!

We disagree with the often mentioned comparison with Reaganomics. The debt to GDP starting point for Raegan was 40% and now we are closer to 80%. The room for maneuver is much more limited.

Europe is following the US at the usual 9-month distance. Unemployment is higher but so is the structural level of unemployment. This means that while the labor market is strengthening here as well, and especially the Spanish economy is doing very well, the ECB will have an increasingly difficult time not to taper even more. The only major worry we have in Europe is Italy. This country desperately needs reforms, a banking sector clean-up and hopefully it will not be downgraded to junk too soon…

Emerging markets in the line of fire

We attach a higher probability to an overheating US economy and thus higher yields and Fed action. Especially emerging markets are in the line of fire. In the long term, currency devaluations will help stabilize emerging markets as they regain competitiveness, but in the short term a strong US dollar and capital flows will hurt a lot more.

With Trump we might enter a new era of protectionism. But within emerging markets the famous capital controls will become in vogue again. If this higher Fed level and strong US dollar work out, some currency pegs will come under pressure and capital flight will hurt current account deficit countries. Higher yields to keep money in, currency interventions depleting, inflation rising and low economic growth do not go well together. We remain cautious.

Our conclusion is simple. It is likely that the Trump election extends the business cycle and gives the healing process more time. Central banks might have to react. At the same time it will aggravate corporate releveraging and postpone the inevitable, an even more painful slowdown. Debt levels are still rising and the world desperately needs higher inflation. It is just a possibility that one might not expect this anymore, just when it becomes real. Central bank QE tigers will then withdraw and the wolves will be coming.

Positioning: neutral beta, seizing temporary opportunities

We stick to neutral betas. The technical support as a result of central bank policies is simply too strong to ignore. However, we realize that market sentiment can turn quickly as many market participants are aware that they are uncomfortably long. These bouts of unrest can temporarily provide opportunities. We will not hesitate to capture these and accept an increase in portfolio beta but from now on with the knowledge that in the near term monetary stimulus will decline.

We also stick to our preference for European over US credit. The US credit cycle is too far advanced and more vulnerable to a turn for the negative in global growth. We need more spread compensation, maybe driven by the fear of the Fed, to go overweight the US.

We nurture our short beta position and quality bias in emerging markets. This year that has not been the best position and emerging market volatility occurred primarily in local markets. However, we are approaching the moment when less monetary stimulus will also affect emerging credit markets.

Finally, 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. European financials still offer value and are actually still derisking unlike the non-financial sectors. A special mention for the insurance sector: this may be a great hedge versus rising yields should this occur.

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