We are skeptical of the idea that central banks are infallible. It will require a degree of nimbleness – and luck – to keep up with the swings in short-term market sentiment.
For the first time in 46 editions of this Global Credit Quarterly Outlook we feel there are multiple turning points in credit cycles that simultaneously have an impact on markets. A secular trend of deglobalization is under way, fueled by widespread populism, which will cause trade tariffs to rise. In the medium term this will put pressure on the advantage of cheap outsourced labor, ultimately eroding record-high margins and potentially limiting the breadth of firms’ global customer base.
A further secular trend is the development of a less economically favorable demographic backdrop, which is changing established trends in saving and investment. Finally, the bursting 12 years ago of the debt super cycle is the main ongoing reason for cautious household sector behavior and for the consequent ineffectiveness of traditional monetary policy.
These secular movements are overlaid with a number of cyclical trends: we are having to cope with a cyclical slowdown in growth, more frequent mini spread cycles driven by lack of liquidity, and central bank interventions due to fading inflation.
Our view is that we are still in a slow bear market, marked from time to time by sugar-rush rallies, just as was the case in the 1997-2002 cycle. Meanwhile, central banks are trying the same remedy to cure the patient – a recipe which ultimately does not work. However, we know it is wise to rather not fight the Fed or the ECB.
A large portion of this industry has been raised with the idea that yields are negatively correlated with asset returns, with higher yields implying tighter spreads. We have now shifted to a regime where lower yields are accompanied by tighter spreads. This has created a correlation amongst asset classes. In combination with poor liquidity and central banks reacting rapidly to financial markets, this makes short-term sentiment almost bi-polar. It requires one to be nimble and to have the capacity to switch quickly from being bearish to being bullish. In short, one has to be smart, quick and lucky.
We do not make it our central thesis to continually trade beta higher and lower. Instead, we believe we are in the phase of the credit cycle when stock picking, regional allocations, sectoral trends and a focus on long-term value have a much higher relative probability of being profitable.
We have become slightly more optimistic on valuations – but not by a lot. Spreads are still wider than during the lows of 2018, but yields are too low to chase the current tightening trend. Our preference is to be slightly long in European spread products, but not in a global context.
The demographically ageing parts of the world may well be undergoing a gradual process of Japanification, with yields inevitably being low. The US could be next, after Europe. In such a low-yielding environment, investors are forced to buy credit in order to enhance yield.
We are skeptical of the idea that central banks are infallible, but we also know that they have the capacity to blow asset bubbles for a short while longer, still. We need a real recession to reset the fundamental backdrop, but the longer that takes to unfold, the worse it will be. For now it seems everyone is cognizant of the risks, but the credit market is not priced for them….yet.
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