We are past the peak of the credit cycle and uncertainty lies ahead. Global growth patterns are diverging and the markets are too, with a shake-up occurring in some segments, while others continue to rally. Fundamentals still look solid and from a valuation perspective, parts of the market are regaining their appeal, but technicals will remain vulnerable as central bank liquidity is reduced. Co-heads of the Credit team Victor Verberk and Sander Bus think the tightest spreads in this cycle are now behind us.
The US economy still looks pretty upbeat, but growth in other parts of the world is cooling to more moderate levels. “No immediate cause for concern, although the degree of divergence has increased,” says Verberk. “However, we should be aware that differing growth rates could also cause monetary policy paths to diverge, impacting US dollar liquidity outside the US.”
‘We think the tightest spreads in this cycle are now behind us’
Valuations have improved as areas of the markets have repriced. As far as Bus is concerned, “The main question is whether the often idiosyncratic recent events that have caused markets to correct will extend to other credit classes. In terms of the credit cycle, we believe markets have peaked and are now steering a new course, with investment grade and some emerging markets as the first segments to move lower”.
This is in contrast to equities and US high yield, which have continued to perform well. “Technicals are still weak with striking correlations between risky assets and central bank balance sheets – a trend that causes credit spreads to gradually widen. Hence the slow bleed”.
Credits are tricky. In a high-growth environment, companies re-leverage and embark on credit-unfriendly M&A. But if there is too little growth, there is more risk of recession and idiosyncratic events. “We’re still in the comfort zone for now, but there are risks,” says Verberk.
More moderate growth in Europe signaled by weaker economic data is not a real threat at this stage. The recovery is broad based and the expansion is still in mid-cycle. “But if the current US growth rate is sustained, the Fed may have to carry out more rate hikes than the market is pricing in.” The extremely tight labor market and absence of inflation are also additional risk factors that could kick in at a later stage and exacerbate the situation.
Tighter US monetary policy impacts emerging markets too, causing the dollar to strengthen and basically sucking dollar liquidity out of the rest of the world. This causes volatility – Argentina and Turkey are two of the most recent victims. As in developed markets, this repricing has so far not been broad based. “Again, the question here is whether this is it or if there is more to come,” says Bus.
Government bond markets are currently experiencing an interesting phenomenon: the three-month T-bill is currently the highest yielding three-month government instrument in the G-10. Not bad for an asset class with safe haven status. “Although, with the US twin deficits and net negative international investment position, perhaps not so safe after all,” comments Verberk. On a hedged basis, US assets are not cheap, causing Japanese investors, for example, to shift out of the US and into Europe.
Some segments of the investment grade market are starting to regain their appeal from a valuation perspective. For example, some bank and emerging market issues, which have seen spreads widen again to more attractive levels. In high yield, CCC-rated paper has outperformed and so the portfolio’s quality bias has not paid off. “But we are convinced that the market is overpriced and therefore comfortable with our cautious positioning,” says Bus. “We prefer European high yield as it offers the same spreads but with a much better average rating.”
The correlation between central bank purchases and the performance of risky assets is striking. With the ECB poised to stop quantitative easing altogether, things are likely to get worse before they get better. The story for technicals hinges on this factor and what will happen from a global perspective as this occurs. The market needs new large credit buyers to replace the central banks. “Reason enough to stay put and not increase risk exposure yet,” says Verberk.
“Hedging costs for US assets remain high, which has redirected flows into the European credit markets. So we still prefer Europe to the US,” says Bus. “We are aware of the crowded long financials position, but still favor this trade.” Banks remain the sector that has seen the most deleveraging and their balance sheets are strong. “They should outperform on a risk-adjusted basis.”
“Valuations have become slightly better and some segments of the market have become attractive, certainly when compared to Bund yields” acknowledges Verberk. “But until we see more evidence that the Fed’s hiking cycle will not derail growth and result in offshore dollar shortages, we will remain cautious. Slow bleed or not, the credit markets are in for more volatile and uncertain times.”
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