Despite our repeated concerns about high corporate leverage and too much risk appetite, it is only now that credit markets are beginning to react to the global economic slowdown, and the next recession is being openly discussed.
The demise of General Electric, and the plethora of overrated BBB investment grade companies, highlight the misallocation of capital that has characterised markets over the last year. Co-heads of the Credit team, Victor Verberk and Sander Bus, believe 2019 will herald a turning point for markets.
The turning point will be reflected in two respects. We expect fundamentals to become more important than technicals in 2019. “Credit has been in a rolling bear market for 9 months already, and typically this should not last for more than another 6 months”, says Bus. “Although valuations are now at more attractive levels, this correction is not broad enough yet”.
Verberk expects central banks will change course on monetary policy in 2019. “With shrinkage in the Federal Reserve’s balance sheet, the end of QE in Europe and wider credit spreads, monetary conditions are now much tighter. Central banks will have to change course and adopt a more neutral stance. So, do not be surprised to see a pause soon in the hiking cycle.”
On the surface, US economic indicators remain positive but dig deeper and the picture is more concerning. “Momentum in economic activity peaked in the summer and is much lower now. With the rest of the world already facing a slowdown, markets are starting to worry”, says Verberk. Warning signs are also flashing in market-related indicators. “CLO issuance is tailing off, funding rates are higher, and the tightening cycle is now starting to hurt”.
However, while corporate leverage is massively higher, this has not been reflected yet in credit ratings. “A recession would take leverage to high yield levels for many BBB rated companies and downgrade potential in this segment of the market is high” he adds.
In Europe, Bus notes two big differences with the US. “The first is political risk. While Italy remains a cause for concern, this has largely been priced in by markets. Secondly, corporate Europe has been behaving much more conservatively than corporate America, and is much less leveraged. Misallocation of capital is therefore less of a concern”.
In emerging markets, while the trade dispute with the US has dominated the headlines the real problem rests with the Chinese economy. Despite monetary stimulus, domestic activity is not accelerating. “With China being a major contributor to global growth, following its health is more useful than forecasting a recession in the US. The downward trend in commodity prices highlights real economic growth is already decelerating”, explains Verberk. “The most important source of risk is the renminbi. Devaluing the currency would be severely deflationary globally”.
Markets are still placing too much hope on solid US economic fundamentals. “History tells us it is seldom good for risky assets if the Federal Reserve starts hiking”, explains Bus. “We are most cautious on US high yield and US investment grade credit. Fundamentals will start prevailing, and we just need a few more idiosyncratic events to occur before hope becomes despair”.
From a valuation perspective, we selectively favour European financials and Asian emerging market debt, which have already repriced a lot. “We would compare this downturn with the 2016 sell off, not with the financial crisis of 2008. We are not expecting a systemic downturn, just a shallow one with any recession being shortlived”.
“The dollar money market curve has already been inverted for a while”, says Verberk. “But it was not until October that markets began to adjust to a slower growth environment. It basically indicates a Federal Reserve policy that is behind the curve right now. We need this indicator to start steepening before we become more bullish on valuations”.
However, the outlook is not overly bearish. “The fact that in 2002 we experienced the worst corporate recession, and in 2008 the worst financial crisis, does not mean these occurrences are the norm. A better comparison would be 2016,” highlights Bus. “We are entering a new era with higher volatility, value becoming more appreciated and fundamentals taking over from technicals as the most important market driver”.
“Valuations are fair or at least neutral now, with financials the bright spot. Elsewhere, we expect more turbulence. Betas will be as close to neutral as possible with a bias to be long via European financials”, says Verberk highlighting the implications for portfolio positioning.
“We will be underweight US credit in both investment grade and high yield bonds, maintaining the quality bias in the latter as much as possible. Long-dated US credit, especially, looks vulnerable, and we prefer shorter-dated issues. We prefer Europe over the US, particularly in the high yield market where spread levels are higher in Europe for similar ratings”, adds Bus.
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