November 30, 2019
Credit Outlook: A Year of Two Halves - Technical Is Temporary, Quality Is Permanent
November 30, 2019
2019 saw the risk of recession recede (Godot did not arrive), demand for credit rise (strong technical), and value in security selection (don’t buy debt just because it is in the index).
Looking to 2020 we identify a credit-friendly backdrop supporting credit performance:
As we move to the second half of 2020, we expect the uncertainty experienced in recent years to repeat, impacting confidence that the economy is rebounding. Whether the cause is fear of a recession, political volatility, or liquidation of credit positions creating a weak technical, we believe the result will be a year of two halves that warrants active management of credit, and reducing risk following periods of spread tightening by rotating to higher-quality, shorter-maturity credit.
2019 has been a “goldilocks” year for credit, which has benefitted from both lower risk-free yields and tighter credit spreads. The market expected a recession that didn’t arrive, earnings that didn’t significantly fall, and a weak technical from forced liquidation. We end the year with markets discussing Investment Grade credit in Europe as the new “risk-free asset,” given negative yields on government bonds. The consensus view that economic data globally is “bottoming” suggests we will likely rebound from a mid-cycle slowdown, which generates strong demand for all forms of credit.
We believe the market consensus of improving global growth from a low base seems reasonable. While confidence remains brittle, the macro economy looks to be bottoming, with growth prospects improving in 2020 supported by global central bank monetary policy accommodation. Corporate profitability is expected to consolidate, helped by cost cutting driven through technology substitution, efficiencies, and lower interest costs, while leverage stabilizes as management identifies more debt as a risk to shareholder valuations. Demand for credit is robust, with no let-up in the need for yield given the excess liquidity in the system. We are positive on risk assets in the short term and credit spreads broadly.
Looking further into H2 2020, we see risks for the investment backdrop. Whether the risk is a reversal of confidence in the economy (labor market/consumer weakens) or an increase in political uncertainty (U.S. election in Q4, global trade, popular politics), we expect some volatility that warrants selling credit into a rally given valuations that are currently below the long-run average.
The main themes impacting credit markets can be summarized as a preference for the consumer over industrial. The consumer is supported by low unemployment, low energy costs, and low rates sustaining purchasing power. We have a bias to own financials, unchanged from previous years, which reflects the regulatory demand for risk reduction. We have a bias against non-financials as shareholder-friendly activity remains a negative risk. Additionally, many of the issuers are “old industrials” that are most exposed to technology as well as social change, making them prime candidates for disruption.
In Investment Grade, active management within the A/BBB sector offers opportunities. We expect the trend of increased BBB market share to continue (Display 1) as management optimizes balance sheets to maximize shareholder returns (avoid the A-rated transitioning to BBB). The type of corporate we want to own are BBB companies that demonstrate business flexibility through dividend cuts, asset sales and cost cutting to protect their rating. This was a theme of 2019.
Source: Bloomberg, November 2019. Indices used are Bloomberg Barclays U.S. Corporate Index, ICE BofAML U.S. Corp BBB Index, Bloomberg Barclays Euro Aggregate Corporate Index, Bloomberg Barclays Euro Aggregate Baa Index. The index data is provided for illustrative purposes only. See Disclosure section for index definitions.
In High Yield, 2019 was notable for the dispersion/bifurcation in the market. Good companies are trading expensive, reflecting the positive backdrop of low defaults and demand for yield, but any bad news and prices fall with a step function. While this may become the norm and argues for active credit selection, our expectation is for low defaults to continue making high yield an attractive asset class (Display 2). By region, the U.S. economy continues to outperform Europe, with domestic corporates performing well, while Europe is supported by a lack of positive yielding assets.
Source: Moody’s, August 2019
Loans have underperformed in 2019 as retail outflows, weaker economic growth and the lack of price appreciation from the risk-free duration impacted returns. In 2020, we see opportunities in Loans as improving economic growth and better technicals (supported by CLO demand) drive performance. With U.S. corporates seeming to perform well, we see no imminent catalyst for rising defaults in H1 2020.
Emerging Credit continues to offer value as corporates run conservative strategies supported by fiscal discipline given the idiosyncratic risks associated with the Sovereign backdrop. We expect continued strong demand for higher-yielding EM corporates in H1 2020 and also see value in high-quality infrastructure issues in shorter maturities in a risk-off environment. By region, we see value in Asia. Although China will continue to dominate supply, we see value in China property, while Indonesia should benefit from global monetary stimulus. In the Middle East, we see opportunities in the growing bank hybrid sector, and in Latin America, look to Mexico and (to a lesser extent) Brazil.
Convertibles offer opportunities in 2020 against a backdrop of a late-stage rally in stocks and volatility that is priced at low levels. By region, we prefer U.S. Convertibles as growth expectations are higher in the U.S. and valuations at the issuer level look more attractive to bond investors.
2020 starts with market confidence that central banks can extend the business cycle, politicians won’t derail the process, demand remains strong for credit and liquidity remains plentiful. As the year progresses, we expect periods of market volatility and reduced credit demand triggered by monetary policy fatigue coupled with political noise. To preserve capital and performance we advocate reducing risk following periods of spread tightening through a rotation to higher-quality, shorter-maturity credit.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. In addition to the risks associated with common stocks, investments in convertible securities are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation, and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
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