Perplexing complacency in credit markets

Perplexing complacency in credit markets

06-07-2017 | 四半期アウトルック

Robeco’s Credit team sees a world full of imbalances that can last for years or correct at any time. The team remains worried about complacency and expensive markets, but acknowledges that markets can remain complacent and expensive for a long time. There is still a lot of liquidity searching for return.

  • 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

  • The credit cycle is aging but, despite many imbalances, it does not seem to turn yet
  • High valuations are no longer pricing in fundamentals
  • Most unexpected risk might come from China and weak commodities

The world is full of imbalances: disruptive activities of central banks, unprecedented emerging markets credit growth, and so on. Valuations of risky assets are high. That is how markets work, though. Markets can be complacent for years. We realize imbalances can burst or deflate at any time, for any reason and thus unexpectedly. By the way, the most perplexing complacency we find is in China, comparing real growth and credit creation. The risk of a major deflationary growth slowdown is increasing.

Economically we still have a bit of time. Europe is in full expansion mode. The ECB is however slow to raise rates, since the one thing it has not been able to create is higher inflation expectations. That is still its main worry. We cannot entirely explain the lack of inflation given where labor markets are. A big risk is that sooner or later, central banks will be behind the curve since wage growth does accelerate unexpectedly.

Rising US income inequality is cause for concern

In the US, the current economic soft patch might well be transitory. We have been concerned about a number of leading indicators that might point to economic weakness. Profit and margin contraction, a flattening curve or a very weak capital spending cycle all show that this economic expansion is vulnerable. And we have two other concerns. The first is rising US income inequality. Historically, nations that really manage the equality of opportunity instead of equality of outcome, thrive better than economies where the ‘haves’ and ‘do not haves’ are permanently split. This elite overproduction seems to have become embedded in US society. It might also partly explain our second concern.

Subprime lending has been booming again. Car loans, student loans and credit card debt delinquencies are on the rise. In automotive subprime lending, delinquency levels are at levels we have not experienced since 2007/2008. Despite the fact that Quantitative Easing (QE) has led to enormous wealth creation, it has been distributed very unevenly. This means that low and middle income households have a difficult time servicing their debt.

Although the US economic recovery is still subpar, the good news is that earnings have surprisingly recovered, banks are still in full earnings mode and the labor market is solid. For now, nothing points to an immediate recession, but we do expect this to happen in the next two years.

Consistently at the forefront of credit management
Consistently at the forefront of credit management
Credit investing

China pressing the debt creation button

And then there’s China. No matter how one looks at it, credit growth is far too high versus nominal growth. Chinese policy makers are pressing the debt creation button too often. The economic growth trend is getting lower and interrupted by short mini cycles. In these mini cycles - the last example was in 2015 - policy makers panic when growth becomes too low, and press that button again. Credit growth, driven by state-owned banks providing credit to state-owned corporates, is unbalanced, goes towards unproductive parts of the economy and has reached dangerous levels. We are not here to forecast bubbles, but the chance of China entering a serious growth slowdown somewhere in the next years is almost certain. A key indicator to watch will be Western exports to China.

Valuations have become tighter. High yield is entering the first or most expensive quartile of historical spreads. Investment grade or emerging markets are behind at just under median spreads. Credit market behavior teaches us that these valuations can be sustained for years. So, there is no reason to panic, just be more cautious. We find most value in specific pockets of the global credit market, such as European financials and insurance companies.

Technicals are relatively stable now. Central banks are very predictable, election stress is gone for now and a wall of cash is looking to be invested.

Cautious positioning and tactical trades

There is not a lot of time left in this cycle, but maybe a bit more than we previously thought. It does mean however, that we need to invest cautiously, as tail risk in capital markets has been priced out completely. We manage betas close to index level. In high yield and emerging market portfolios we allow for the beta to drop just below one, since we want to buy only the highest credit quality. In investment grade we maintain the beta at one. We have a preference for European credit markets over the US. The US credit cycle is too far advanced and more vulnerable to a turn for the negative in US growth. We maintain a persistent focus on quality while looking for relative value opportunities in specific sectors or markets, often via more tactical trades.

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