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Credit outlook: TINA is still singing

Credit outlook: TINA is still singing

17-12-2020 | Quarterly outlook
Markets are pricing for the best possible outcome. But, should any unexpected combination of negative surprises arise, conditions could become more bearish.
  • Victor  Verberk
    Victor
    Verberk
    CIO Fixed Income and Sustainability
  • Sander  Bus
    Sander
    Bus
    Co-head Credit team
  • James Stuttard
    James
    Stuttard
    Head of Global Macro team and Portfolio Manager

Speed read

  • The recovery is spreading across more parts of the economy since Q2
  • Investors have few alternatives, though, to make a decent return
  • Markets are priced for the best possible outcome, while the variation of outcomes is large
Barring a potential Brexit surprise, most key potential negative events have been priced out by markets. From Covid-19 to the US elections and a default cycle – we have had it all in the shortest credit cycle ever, says Victor Verberk, Co-head of the Robeco Credit team. “Right now, the variability of outcomes in terms of market prices has increased significantly for all asset classes. And yet, like Tina Turner sang, ‘simply the best’ set of outcomes is being priced by markets. In reality, there is always something that surprises markets.”

Markets are ahead of fundamentals

Sander Bus, Co-head of the Robeco Credit team, says we’ve seen the fastest drop in economic activity in seventy years. “Spreads reached very substantial levels and the US high yield default rate reached 8%. Thanks to a well-coordinated series of policy actions by fiscal and monetary authorities, a recovery set in quickly. That is, a market recovery set in. Our view is that markets are now ahead of fundamentals, as we also stated in the last Quarterly Outlook (‘Markets already have the vaccine’).”

“We have written about TINA (there is no alternative) before,” says Verberk. “Tina Turner also sang about being ‘simply the best’. This is how we feel about current market pricing. It is indeed possible that markets will carry on delivering returns in 2021 that are reasonable but lower. However, for this to be the case, a lot of things need to be in positive alignment at the same time, given the fully-valued starting point – and given that we will not see a supernova of policy action again. Since we know economic activity does not have much to do with market returns, the increasing breadth of the economic recovery does not make us more bullish per se.”

All in all, we are concerned that markets are ahead of fundamentals. If we look at all possible outcomes fundamentally, on Covid-19 or an earnings recovery, it will at best be a boring year with small returns. Should there be any unexpected combination of negative surprises on rates, policy errors or defaults, conditions will become more bearish.

“We still find value in pockets of the market in individual situations. The big beta play is done, though; it’s back to stock selection and being more cautious,” says Verberk.

Bus says one could easily conclude that markets have priced out the Covid-19 crisis. “Corporate spread levels are within 10 bps of the starting levels of 2020. Spreads are close to the levels where the rally normally stops. Only a full-blown Japanification via permanent excess liquidity could cause spreads to rally meaningfully from here. Given the strong technicals, that is possible, but it is not the central scenario.”

The year will be either boring or bearish for credits

Verberk describes 2020 as having been a year of many opportunities. “There was a beta opportunity in March, a cyclical recovery opportunity in June and, later in the year, a Covid-19 sector theme opportunity. During this time, we did rigorous research in order to keep portfolio free from the effects of defaults and accidents. We again succeeded, with much lower defaults in high yield than in the index, and not one in investment grade.”

He says conditions could be more difficult from here onwards. “The possible variation of economic and technical outcomes is large. The year will be boring or bearish. There’s hardly any room for aggressive tightening. At best, we’ll see some carry, roll down and certain sectors recovering from Covid-19. While there is something left on the table, it isn’t much. We cannot afford to have policy errors, rising yields or inflation, nor could we have any oil price, political or geopolitical shock. There is just not enough cushion left. We faced the same asymmetry this time last year. So, it will be either boring, with a small excess return, or bearish, should one of these events occur.”

Fundamentals have improved, but caution is called for

Verberk concludes that fundamentals have clearly improved and that the recovery is broadening. Valuations have deteriorated a great deal and technicals remain constructive.

“We stay cautious in high yield. Single-digit returns can be expected, at best. For investment grade, it’s possible that total returns could become negative for the first time since 2018. Breakeven levels are very low. In emerging credit, we have been very cautious and have the view that there is some room to increase the beta a bit to above 1.”

Source: Robeco, December 2020

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