The degree of distortion created by the reopening of the economy is significant. Even famous economists and central bankers are changing their views and hesitating. Victor Verberk, Co-head of the Robeco Credit team, says, “At times like these, it is best to be humble about the unknowns and to just accept that, every now and then, it is difficult to see the forest from the trees”.
A few things are clear, though. Barring accidents, the US should post nominal GDP growth of 10% this year. That said, growth in industrial production seems to be peaking and the fiscal impulse is set to roll over first in China, then in the US. It means markets are priced for the current perfect recovery but not for future uncertainty.
Governments have taken on extraordinary powers in the past 16 months. Might some leaders be tempted to perpetuate an era of big government post-Covid? “Corporate tax rates, the scale of central planning and interference in free markets all seem more open to question after four decades of a more hands-off ‘neoliberal’ era,” says Verberk.
“Some large, dominant mega-cap companies look set for a crackdown. Meanwhile, labor may take a bigger part of the GDP pie at the expense of profit and margins. We do not find evidence of this via our own analysts, but it could be a multi-year process. The long-term inflation outlook is uncertain, even if some consensus pro-inflation arguments look suspect. The post-Covid era, assuming eventual vaccine success, may bring substantial change in many underlying trends.“ Sander Bus, Co-head of the Robeco Credit team, says, “With spreads now near an all-time tight, a cautious positioning makes sense to us. Still, it will be a boring (most likely) or bearish year for credit. Dispersion between issuers is now at record lows as the rising tide has lifted all boats. You are not compensated for the risk when you reach out to lower-rated bonds. We stick to quality issuers.”
The fundamentals are firm, but they’ve been flagged for some time
The recent Fed communication shows that there are varying opinions on timing of tapering and on the timing and magnitude of future rate hikes. Chair Powell concludes it is appropriate at this stage only to talk about talking about tapering. The Fed statement felt a bit hawkish, given the comments on inflation. Though this is just one meeting, markets will be very sensitive to a permanent change in tone. Fed members themselves suggested they need to be humble. These are uncertain times for them, too.
And, what if inflation proves not to be transitory? Indeed, there are some potential drivers, particularly on the fiscal and labor market fronts, that could cause inflation to have some legs.
At the same time let us not hyperventilate about inflation, says Robeco credit strategist Jamie Stuttard. “We do not expect a return to a 1970s-style inflationary period. Ongoing technological progress, the laws of comparative advantage, unit labor cost arbitrage, the private sector profit motive, western demographics, and the curtailed power of labor relative to the 1970s are factors too dominant for that, in our opinion.”
As for the cycle, the conclusion on fundamentals is that the current phase of the economic recovery could hardly be better. After all, we are only in the first few quarters after the recession. But, to us, the issue is that this has all been well-flagged and framed for a while. What if there is disappointment in follow through or, alternatively, what if tapering is brought forward?
Valuations suggest vulnerability
It is clear that recent months have been mildly positive in terms of excess return in credit markets. “In that sense, we have been a bit too early in bringing down our beta,” says Bus. “At the same time, it strengthens the case that probability-weighted, future expected returns have deteriorated further. We stated it would be a bearish or boring year for credit, with boring being the most likely (and best) outcome. At current spreads the cost of running a small underweight beta is very low. Breakeven levels have come down tremendously.”
Results from stock picking have been good but, to be honest, there are fewer outliers now than a few months ago. In general, the economic reopening trade has been played. Even higher-risk sectors like airlines and cruise liners or the leisure sector have all recovered to pre-Covid-19 levels. Full compression is here.
Emerging credit has lagged the rally a bit. We see more upside here. There are a few challenging sovereigns, like Argentina or Turkey, but the energy sector, for example, seems still attractive. Globally, we keep finding idiosyncratic situations in corporates and financials that warrant more research and taking long positions.
The conclusion on valuation is that the room for error has become smaller again. The Fed’s May financial stability report highlighted that valuations in many markets are now vulnerable to any deterioration in risk appetite. Here, again, is a reminder of the importance of always expecting the unexpected: that’s how markets work.
We are happy to have a small underweight beta. It is small enough to ensure that via stock picking we can deliver a decent return and some outperformance.
Beware confirmation bias
After so many months of positive excess returns, it is human to start extrapolating the series and expecting a continuation. And confirmation biases indeed play a role: it is increasingly hard to justify and explain the end of such a long streak of winning excess returns. It is a time in which debates within the team heat up. It is also a time to be humble and accept the many unknowns that lie ahead.
The bottom line is that technicals are still strong. “It is the change we are concerned about,” says Verberk. “Together with the fundamental and technical situation being so well flagged, we do not think June 2021 is a buying opportunity. Talking about buying opportunities, the last 13 years supplied us with five big buying opportunities. This is one every 2.6 years, on average. Just a fun fact for a very contrarian active credit team.”
Most likely, the credit market will at best deliver a coupon excess return. “A boring year, in other words,” says Bus. “We think it is better to be positioned on the cautious side. ‘All signs on green’ has become the widely shared view for credit. This is a market that no longer compensates for tail risks and which is vulnerable to negative surprises. Confirmation biases rule.”
We are not running huge underweight betas, though; our positioning is just below one. Given the very low dispersion in markets, it no longer pays to reach out for the riskier names. Nevertheless, we still find opportunities in banks, Covid-recovery trades and some idiosyncratic cases. Our positioning is consistent across all credit categories.