Following last year’s bear market, credit has traded in a range over the past six months – a remarkable performance given the slowdown in economic growth. Since last quarter, rates markets have been much more volatile than credit.
Jamie Stuttard, Fixed Income Strategist and Head of Global Macro Fixed Income at Robeco, observes that, “Ominously, more segments of the US yield curve have inverted: historically, on five out of six occasions of US yield curve inversion, a recession followed within two years. On the sixth occasion we ‘merely’ saw an emerging market crisis (1998). Based on history, credit spreads can move sideways for up to six quarters after a curve inversion but ultimately have always widened substantially”.
The sequencing may be different this cycle – and the developments faster – given that it took 21 months last time between yield curve inversion and the Fed cut, but this time the Fed has started to cut before the curve inversion. More optimistically, money supply is increasing and recent corporate bond supply volumes are setting new records.
But global fundamental developments suggest more caution, says Sander Bus, Co-Head of the Credit team at Robeco: “The US economy used to lead the global economy but, since 2015, it now seems to be the other way around, with China being the driver of global growth – this time on the way down. The yield curve and global trade tensions, if the path of escalation continues, point to a high probability of recession down the road”.
“Globally, credit spreads are tight. Investment grade spreads reflect a willingness by investors to pay up amid negative government bond yields – together with negative and falling cash rates – while high yield spreads are starting to stretch the models,” says Stuttard.
In euros, CSPP-eligible bonds trade at a premium already. ECB Quantitative Easing was largely anticipated by the summer’s ‘sugar rush’ rally. Still we would argue that euro investment grade corporates are somewhat shielded from global weakness – under the ECB umbrella as it were. On a risk-adjusted basis, the investment proposition is therefore more favorable in reality than the headline spread might suggest. Within euro investment grade, we see compression with higher-spread product outperforming as a result of the search for yield.
In high yield we see the opposite: decompression. CCCs have underperformed as these companies struggle owing to the deceleration in economic growth.
US investment grade now trades at a more attractive ratio versus euro investment grade when we compare the similar-rated, similar-maturity spreads adjusted for the cross-currency basis swap.
In a similar fashion to European high yield, the bid for yield has not continued down the US credit spectrum. Lower quality has not benefited in the rally as BBs have massively outperformed.
The ECB’s announcement of Quantitative Easing is different to last time, says Stuttard. “First, you could argue that technically the ECB is barely easing because the rate of net new purchases is smaller than long-run trend nominal GDP growth, which means central bank assets are not moving much higher as a percentage of GDP. Still, the stock effect means ECB QE2.0 is nevertheless helpful for the market. It cannot, however, solve all cyclical risks in credit, let alone the earnings impact of sustained elevated tariffs. We prefer to use the window and tighter valuations provided by the ECB to trim down risk.”
Second, he says, the beneficial international spillover of cross-border European flows into USD credit seen in 2016 is less likely this time around because of flat US curves and much higher FX hedging costs, despite recent and further anticipated Fed cuts.
“We have not changed our late-cycle view. On the margin we became more constructive in the short term during late summer, on the back of monetary easing. But any further strength might be seen as an opportunity to reduce risk,” says Bus.
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