Victor Verberk

Key highlights:

• Global debt is near cyclical highs
• Despite weaker than expected data, markets rallied – a typical bear market rally
• The bar to cutting rates is low, with central banks desperate to avoid a recession
• Corporate margins are under pressure, an earnings recession in the making.
• The Q1 2019 rally looks increasingly like a dead cat bounce

Despite the weaker than expected macro data, risk assets have performed very well since the start of the year. So why have markets bounced so vigorously? A dovish Fed shift, expectations for a China trade deal and the backdrop of an oversold market late last year all help explain.

We see the current rally as typical of bear markets. Nearly all bear markets have occasional rallies, and they are often sharp and painful, just like episodes of spread widening. Sentiment in credit bear markets swings much more wildly in both directions.

In times such as these, when thorough issuer selection pays off, the market will increasingly distinguish between winners and losers. We construct our portfolios cautiously.

We are also conscious of the fact that it is expensive to be underweight. But rather than succumbing to the temptation to be long for the carry, we prefer to get prepared so we can return quickly after markets have repriced.

Companies enjoyed multiple years of expanding margins. Profits as a share of GDP rose to record levels. But those days are over. With wages rising faster than inflation, corporate margins are under pressure. Even consensus equity analyst estimates expect an earnings recession. Central banks are prepared to take aggressive steps in order to raise inflation and have become more responsive to developments in financial markets. But, aside from the moral hazard that this creates even larger asset bubbles in the future, the growth in floating rate markets, such as leveraged loans, means cutting rates may create its own unintended consequences. In our view, this is a dead cat bounce. The downside of this policy, is that it can lead to bubbles and create bigger problems down the road.

Fundamentals: earnings recession around the corner

In this part we look at economic fundamentals, such as economic growth, inflation expectations, debt levels and dollar weakness.

The key question for investors and policymakers is whether we are in a soft patch or at the beginning of an extended period of weak economic data. Central banks seem worried, as demonstrated by their reaction to the weak data. It has become clear that the Fed rate hike in December was a policy error which they have sought to correct with dovish speeches, forward guidance and the announcement of a gradual end to quantitative tightening. The ECB lowered its growth forecast and implemented a TLTRO and China has stepped on the gas as well with fiscal and monetary stimulus. It is clear that policymakers are very eager to prevent a recession. Whether or not they actually can, is questionable.

US

Leverage for US investment grade companies, measured as debt/EBITDA is now well above previous peak levels.  High leverage is worrisome when profitability is still very sound, because leverage will go even higher once the economy slows and profits start to drop. In 2018, companies benefited from lower taxes but they did not pro-actively deleverage in the good times. On the contrary, in many cases they did the opposite, as evidenced by the amount of debt-funded mergers and acquisitions and share buy-backs. This is a typical end- cycle phenomenon: debt rises during the boom years, then earnings fall once growth slows, causing leverage to shoot higher.

At this stage in the cycle, the biggest risks are weakening earnings and, eventually, downgrades (investment grade) and defaults (high yield). We think this is now playing out as evidenced by the many profit warnings that have been issued. Equity analyst consensus estimates are now forecasting a 3.7% year-over-year earnings decline for Q1, with several sectors seeing double digit declines (energy, materials and tech). That is what is referred to as an earnings recession. Margins are under pressure as wage increases can neither be offset by higher selling prices nor by gains in productivity.

But will an earnings recession also mean an economic recession? That is a very hard question to answer and an answer might not even be required in order to predict market developments. An increase in perceived recession risk is enough to make credit markets widen. We see some red flags that point to an increased risk of recession. For example, there is a huge negative gap in consumer confidence between current conditions and expectations. Historically, gaps of this size have always been followed by recessions. We see similar patterns in Germany in the Ifo survey. And the NY Fed themselves model a 1 in 4 and rising probability of recession within the next twelve months given the flatness of the front and intermediate parts of the Treasury yield curve.

So the Fed is very eager to raise inflation and, if they can, to gently steepen the yield curve. We believe that the bar for cutting rates is very low. When further macro weakness becomes evident, which is likely, the Fed will probably cut rates. That could temporarily help sentiment and maybe even extend the cycle, but it most likely will not prevent the earnings recession from happening.

Europe

Europe is much more dependent on global trade than the US. This helps to explain the disappointing economic data from Germany, centered on weak export orders. Year to date, European data has continued to deteriorate, but the recent monetary and fiscal stimulus in China should help to improve things somewhat going forward. It is worth noting that European companies have been comparably more disciplined when it comes to debt-funded mergers and acquisitions and, in particular, share buy-backs. So even though European corporations are more exposed to a global slowdown, their balance sheets are generally less vulnerable than their US counterparts. Political risk is as always an issue in Europe. The Brexit process, May elections and Italian sovereign questions all remain outstanding, even if markets are fairly relaxed on this front currently. The rise of non-centrist politics is still a theme that should not be overlooked. It is a long term challenge to the status quo which could reverse the economic benefits of global trade and globalization.

Emerging markets

In emerging markets, both private and public sector debt ratios have continued to move up at an alarming pace. Excessive debt is a ticking macroprudential time bomb for a number of economies. Emerging market dollar-denominated debt as a share of both GDP and exports is now as high as it was in the late 1990s. Waves of stimulus have caused total debt in China to soar to a staggering 270% of GDP. Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. Still, another round of stimulus is currently being implemented and will probably help prevent growth in China from dropping below the lower boundary. Chinese authorities are being more careful this time around as they are conscious of the negative consequences of excessive debt, so measures are focused on partly unwinding some of the tightening policies that were implemented last year and reducing VAT.

Valuation: back to tight levels

In this section we look at valuations – which market segments look rich and which offer room for spread tightening?

Markets have been very volatile since our last quarterly outlook in December. They crashed towards the end of the year and recovered in the first few weeks of the new year almost as quickly as they had come down. At the time of writing, global high yield had a total return of 6.5% year to date, which is more than what most market participants, including us, would have expected for the entire year. We see that spreads for almost all credit categories have again moved to well below long-term averages. US investment grade and high yield spreads are the most expensive at 75% and 71% of the long-term average. We feel that this is expensive given the current point in the cycle. Euro investment grade is the exception with a spread that is currently still close to the long-term average, which we would call a fair valuation.

Within high yield we see a striking disparity between high quality and low quality. CCC rated bonds strongly underperformed during the crash in December.

Interestingly, they continued to underperform on a beta-adjusted basis during the rebound in the first quarter. This is another indication that this is a bear market rally, rather than a genuine recovery. The underperformance of CCCs can be explained by underlying pressure on corporate profitability which for these weak credits immediately challenges the viability of the business model. And it’s not just CCCs: 30yr BBBs have not kept up in beta terms with BBBs across the curve and second lien loans are underperforming too. So we can see at least three signs within the structure of credit markets that 2019’s price action looks like a bear market rally.

For global portfolios we see some tactical value in Asia, as spreads are still wide versus developed markets and this market will benefit the most from the Chinese stimulus program. But longer term, we remain cautious about emerging markets, as many of them are facing unsustainably high debt levels. In developed markets, we continue to favor European markets, since these are more appropriately valued and tend to have better fundamentals in the form of lower leverage. In addition, Europe will benefit more from Chinese stimulus in the short run.

Technicals: selling the rally

In this part we discuss technical factors, such as increasing US dollar hedging costs, investors pulling out of the US and the shift from bank funding to capital market funding.

A dovish central bank usually means risk on. This time was no different, as we have witnessed in the first quarter of 2019. Sentiment had shifted too far in the negative direction at the end of 2018 and investor positioning was very defensive. So it is not surprising that the markets rallied once central banks reversed course. The big question is, is this a bear market rally or not? We believe it is.

As we wrote last time, the credit bear market started in early 2018. Nearly all bear markets have periodic (usually multi-month) rallies, and they are often sharp and painful, just like episodes of spread widening. This is a credit bear market, in our view, where sentiment swings much more sharply in both directions. And as a result, you have to fight the urge to chase the market when everything starts to feel much better, as it does today, unless the fundamental story has truly changed. Also, don’t forget that in an average cycle, the bulk of spread widening actually happens after the hiking cycle is over, because that is when growth weakens the most. So a pause in the hiking cycle is not usually the best time to be adding risk. In fact, of the last seven big bear market rallies we can find, the Fed cut rates in five of them. As for the other two, in 2002, the Fed had already cut by over 400bps and in 2014, rates were still at the lows so the Fed weren’t able to cut.

Fed and ECB easing has pushed rates down and that undoubtedly starts the process of making credit look attractive in relative terms. It is expensive to be underweight credit. This applies even more to Europe where the alternative has a negative yield and where the government curve is still steeper than in the US. It is tempting to pursue the carry trade, but this is not the right time in the cycle to do that. It is akin to collecting pennies in front of a steamroller. At the same time, it is important to understand this technical, as it will mean that investors will probably quickly return after a sell-off.

Apart from central banks there are two other factors that are worth considering. BBB issuance and the state of the leveraged loan market. BBB issuance has ballooned since the financial crisis as investment grade companies have engaged in debt-funded share buybacks and mergers and acquisitions. In many cases, rating agencies have so far been very forgiving and have maintained investment grade ratings on the promise of deleveraging. With the outlook for corporate profitability looking more clouded, it is likely that we will see a large number of fallen angels dropping into the high yield market. That will create opportunities, as these companies have enough levers to pull to ensure their survival, but it is better to avoid this segment now and be very selective in what you buy. This is where having a strong analyst team really helps, where active management can really make a difference.

The leverage loan market is where we see the biggest bubble in today’s credit markets. The US leveraged loan market has ballooned to USD 1.13 trillion, of which more than half has been pooled in collateralized loan obligations, or CLOs. That is not a problem, as long as profitability remains favorable, but today’s lax lending standards will contribute to painful losses in leveraged loans in the next recession. These products have often been sold on the premise of a secure asset class with a floating rate that protects against rising rates. Since central banks have reversed course and money market rates are no longer going up, flows into the loan market have turned significantly negative. So paradoxically, a looser monetary policy stance has actually started to tighten the availability of credit through the leveraged loan market.

Through what transmission channels could weakness in the loan market filter through to bond markets? First, the two markets’ issuers partly overlap. So if loans widen, bonds are likely to follow suit. Secondly, multi-asset credit funds that invest in both categories might have to sell the more liquid bonds if they face outflows since loans are hard to sell. Finally, increased supply in the bond market as companies struggle to refinance maturities in the loan market could also be a means by which bond markets are affected.

Positioning

How will we position our credit portfolios in the coming quarter?

If anything, our conviction is strengthening that spreads will trend wider over the medium term. The fundamental challenges that have built up over the course of a nearly decade-long bull market will gradually rise to the surface, and the credit cycle is starting to turn. After the huge sell-off in December, we added risk early this year. Investment grade portfolios saw their betas climb well above 1 and for high yield we moved the beta to 1. But then in early March, we faded the rally and reduced betas again, taking profits.

We now feel comfortable with a beta of 1 for investment grade and below 1 for high yield. We have a clear preference for Europe over the US for all global portfolios. Our portfolios are defensively constructed. Within investment grade, we still like European financials in core Europe. We expect the underperformance of lower quality, high beta names to continue. This is not the time to reach for yield.

Liquidity in credit markets is still challenging. This means there is a need for a contrarian investment style: sell when things look good and buy when markets get ugly. December was a good example of that. And early March another. We will only know in Q2 if the cat is dead, but for now, it looks decidedly ill.

Guests

We would like to thank the guests who contributed to this new quarterly outlook . The views of Winifred Cisar (Wells Fargo), Michael Anderson (Citigroup), Robert McAdie (BNP Paribas) and Rikkert Scholten (Robeco) have been taken into account in forming our credit views.

By , credit strategist.

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The post Dead cat bounce: Credit Quarterly Outlook Q2 2019 appeared first on AdviserVoice.

Sander Bus

The US economy is growing above its potential. Job openings are now exceeding the number of unemployed workers. In this environment it is no surprise that the Fed is continuing to hike. Tighter dollar liquidity is putting pressure on non-US issuers that rely on dollar funding. At the same time the ECB is still reluctant to tighten monetary policy more aggressively.

Divergence between global bond markets has increased in the last three months with US spreads tightening further, while Europe and especially emerging markets have underperformed. We do not believe that the negative correlation between the US and international credit markets can continue indefinitely and would argue that US spreads should widen. We reaffirm our belief – made in our last outlook for Q3 – that the tightest spreads in this cycle are now behind us. And although there is no reason to expect a full- blown crash anytime soon, spreads are likely to widen gradually.

Market technicals are still weak. The fact that the Fed is on a hiking path and the ECB’s quantitative easing is drawing to a close are not helping fixed income as an asset class. The huge supply of US Treasuries could crowd out other financial assets and US investment grade (IG) is right in the line of fire. It makes you wonder who will be the marginal buyer of credit and fixed income in general in such an environment. US insurance companies and pension funds could be potential candidates as they may have an incentive to increase fixed income allocations now that coverage ratios have improved. However, overall we would still conclude that technicals are negative for our asset class.

As always, our outlook is divided into three sections: fundamentals, valuations and technicals. But first, here’s where we think the main credit markets are in the cycle.

Figure 1 | The Market Cycle: mapping our view on market segments

Source: Robeco, Morgan Stanley, September 2018

Where are we in the credit cycle?

We continue to see indications that the cycle is maturing and still feel that spreads probably reached their tightest levels last January. Of course, It is notoriously difficult to predict the exact point at which the cycle will turn and the depth of the ensuing bear market, but since we believe spreads will grind wider we have placed the dots in the bear market phase. This does not mean that there are not still opportunities, however. In this sort of environment, we can expect pockets of the market to occasionally reprice quite aggressively and if such situations result in buying opportunities we will not hesitate to take advantage of these. US high yield has held up well compared to other bond segments, but we think that here too spreads will eventually follow those in other parts of the market and start to widen.

Fundamentals: Economic slack is a thing of the past

In this chapter we look at economic fundamentals, such as economic growth, inflation expectations, debt levels and dollar liquidity.

We are living in interesting times. A number of long-term trends seem to have reached an inflection point. Ten years on from the Global Financial Crisis, there is no longer any slack in the economy. Labor markets have recovered and monetary stimulus is being reversed. Another long-term trend also seems to be coming to an end. Globalization. This has helped to keep inflation low and economic growth high. It was good for corporate profits and financial markets but blue-collar workers suffered. With Trump at the helm this is changing. He is determined to bring the supply chain ‘home’ by increasing trade barriers. The long-term effects will probably be higher inflation (through higher wages) and lower global growth. The short-term effects of lower tax rates, deregulation and a pick-up in capex have propelled risky assets but we do not believe this will be a positive development for markets in the longer term.

US: steaming ahead – but how long can it go it alone?

The US economy is growing well above potential, which heightens the risk of inflation. But as yet figures have remained rather muted, with core CPI ex-shelter still at just 1.3%. However, wages are now definitely moving higher so it will just be a matter of time until this is reflected in the overall figures. And we should not overlook the extent to which inflation is a lagging variable: it could be with us before we are fully aware of its presence.

US investment grade leverage has increased rapidly. In the past, leverage has always peaked in a recession when EBITDA levels have dipped. So in the current environment, it is striking that leverage is now already above previous peaks, while EBITDA continues to grow at a healthy pace.

M&A related debt issuance is one of the main culprits for the heightened leverage. Rating agencies have been quite relaxed about accepting leverage that is ‘temporarily’ at an elevated level. The risk is that this will trigger downgrades if companies do not deliver on their promises to reduce leverage should we move into a more adverse economic environment.

Earnings growth is solid but headwinds will increase going forward, with margins likely to shrink as wage pressure creeps in and input costs rise. But as EBITDA margins are at a high level, we do not see a corporate crisis as one of the major risks.

The US consumer is in a strong position as reflected by consumer sentiment indices. Strong labor markets and wage growth support the consumer. Income growth in the US stands at 5% due to wage growth of around 3% in addition to the increase in the number of jobs.

Europe: political risk overshadows economic fundamentals

Political risk in Europe is still elevated. The political situation in Italy is still reason for concern and could have a significant destabilizing effect, especially on other peripheral markets. The ECB wants to avoid a flare up of a sovereign debt crisis at any price.

Business sentiment in Europe is still positive but industrial production growth has come down. Despite the strong labor market data, consumer spending has continued to slow, but should be supported by wage growth, which is now starting to gain momentum. Core Inflation has so far remained range bound and although it could trend higher on the back of higher wages, the ECB is not under huge pressure to hike interest rates too quickly or aggressively.

At company level, profits are still solid so from a credit perspective there is not too much to worry about in terms of corporate health although it seems unlikely growth will accelerate. European corporates have also been much more conservative in using leverage than their US counterparts, which should make them more resilient in the event of a market turn down.

Emerging Markets: dollar squeeze and China slowdown

Emerging markets are clearly suffering from a reduction in dollar liquidity, with countries that depend on foreign funding (Turkey, Argentina) really feeling the pain. Several have been forced to hike rates in order to stem weakness in their own currencies. The collateral damage if this trend continues is severe economic slowdown.

We cannot talk about emerging markets without spending some time on China. One indicator which highlights the weaker growth in the Chinese economy is the demand for industrial metals. These indices have been declining since the second quarter. They reflect the lower demand for metals in China, which is accompanying a sharp decline in infrastructure spending.

The policy options still open to the Chinese authorities to stem the weakness are also limited. Monetary loosening is no real solution as this would weaken the currency too much at a time when the Fed is hiking. A weak renminbi is referred to as the ‘nuclear option’ as it could spark a widespread currency crisis across Asia. Stimulating credit growth is not an attractive alternative either as China is trying to clamp down on excessive leverage, especially via shadow banking, in the corporate and local government space. The one remaining option could be fiscal stimulus in the form of tax reform. All in all, it will be quite tough for China to avoid a prolonged period of slower growth.

Valuation: Better value to be found in European credit

In this section we look at valuations – which market segments look rich and which offer room for spread tightening?

Spreads in Europe have widened slightly further in the last three months but are still not cheap in historical terms. US credit has continued to outperform and can now be classified as outright expensive. We have also seen wider spreads in emerging markets although this weakness has mainly been in a selective group of high yield countries.

While we conclude that the market as a whole is still not cheap, it is interesting to look at ratios and make some comparisons. If we divide US IG spreads by European IG spreads we see that the ratio has dropped from 1.7 to 1.0 since the start of the year and a very similar shift has occurred in high yield spreads. On a cross-currency-hedged basis we can conclude that European credit is now cheap relative to US dollar credit. In the case of high yield, it is also important to realize that it’s not just a case of a better spread in Europe; the quality of debt is much better too. The average credit rating in the European high yield market is BB, whereas the US market is dominated by single Bs. So we maintain our overweight in Europe, even though the position has not played out so far this year.

Risk on in US High Yield

Since the start of the year CCC have outperformed significantly in the US high yield market. This is clear evidence of the risk on sentiment in the US. CCC also outperformed as this category is perceived to be less sensitive to interest rate increases than higher rated credits. However, at current valuation levels, CCC credit spreads are not offering sufficient compensation for an average default scenario in the next five years and so we avoid this category as much as we can.

Nor are we convinced that the worst is behind us for emerging markets. Spreads are still not wide enough across the board, but we are prepared to selectively take positions in bonds that have undergone significant repricing. For example, we have recently picked up a few high-quality Turkish and Chinese credits that got dragged down by the broader Turkish market turmoil.

For a long time now, we have had a preference for investment grade financials. This is still the case as we still find relatively attractive investment opportunities in this segment. Within financials we will move some exposure to more senior parts of the capital structure as there are some attractively priced senior preferred and senior non-preferred new issues.

Technicals: ongoing headwinds for credit

In this chapter we discuss technical factors, such as global reduction in US dollar supply, increased Treasury issuance and increasing hedging costs.

Although corporate profitability is still strong we believe that the dominant factor for credit will be weaker market technicals. A reduction in central bank liquidity is still the key driver for markets and Fed policy does not only result in higher rates, it also leads to lower dollar excess reserves. The impact of this is mainly felt by oversees US dollar borrowers. It is therefore not surprising that the first cracks have started to appear in the offshore dollar market for some high-risk dollar borrowers (i.e. Turkey and Argentina).

A second technical that has the potential to hurt credit markets is the huge supply of US Treasuries being used to finance the country’s fiscal deficits. Buyers will be found for these issues – they will be priced to ensure that this is the case and other fixed income categories could be crowded out as a result. A somewhat mitigating factor is the relatively mild supply of corporate debt.

Higher short-term dollar rates are also continuing to have an impact on hedging costs. Cross- currency-rate differentials determine the costs of hedging and these have clearly expanded. The logical effect will be a lower demand for US fixed income, at least until repricing causes these to revert to more acceptable levels.

In previous outlooks we have extensively discussed the end of quantitative easing in Europe. This event is well flagged but still important for the market. The ECB’s CSPP and PSPP programs are now in their final stages. In the foreseeable future, the biggest net buyer of European credit will limit it’s purchasing to just reinvesting coupons and redemptions. European IG spreads have already widened significantly from their tightest levels in early 2018 in anticipation of this.

Ballooning BBB universe

Another market technical we discussed is the massive growth of the BBB universe in both Europe and in the US. Since 2010, This segment of the market has more than tripled in Europe and more than doubled in the US. In itself, this is not a major issue. But if the tide turns in the market and rating agencies are forced to take action, the relatively small high yield market could be inundated with a wave of ‘fallen angels’ as companies lose their IG status. Given the still solid outlook for corporate profitability, this is not a theme that should upset markets in the short run, but in a weaker market environment it could make matters worse.

As a final point we would like to discuss interest rate coverage. According to this metric, credit quality still looks sound although coverage levels have slipped somewhat due to higher debt levels. Rising EBITDA is a mainstay for interest-rate coverage ratios as are the declining average coupon levels. However, we have now reached a point where new issues no longer print at a lower coupon and, although this is a gradual process, we should realize that the tailwind offered by refinancing into lower coupons is behind us. For companies that use leveraged loans as a main funding source (an increasing number of companies are loan-only financed) the coverage ratio will decline much more rapidly in an environment of rising Libor rates. This adds an additional vulnerability to the loan market, which is already rife with aggressive financing structures and over leveraged businesses.

Our conclusion is unchanged from our previous quarterly outlook. Technicals continue to look vulnerable.

Conclusion & positioning: caution in world of shrinking liquidity

How will we be positioning our credit portfolios in the coming quarter?

Cautious positioning despite improved valuations

Valuations have become slightly better in Europe and emerging markets, but not enough to justify a more aggressive positioning. Caution is warranted in a world of shrinking liquidity. In the new era of tighter monetary policy, we are probably going to see more instances of aggressive de-risking in pockets of the market. This can offer opportunities in situations where repricing has caused markets or individual issues to overshoot. We will be on the look out for these opportunities as they arise and will be proactive in taking advantage of them. At the same time, we will also make sure that our portfolios are defensively positioned. We expect most of these opportunities to arise in the emerging markets space.

Euro credit is cheaper in relative terms

Hedging costs for US assets are high and this makes Euro denominated assets look cheap on a relative basis. Our preference for Europe extends to both the investment grade and high yield segments.

Quality financials look attractive

In Europe, we see still see value in financials, although we are very selective in terms of the quality of the issuers in which we invest. Within this space we are increasingly seeing value outside the most junior parts of the capital structure, so we have move some investments into senior preferred and senior non-preferred debt.

Conclusion

All in all, these are quite challenging times for credit markets. Tighter global monetary policy, diverging growth patterns in the major economic regions, shrinking dollar liquidity and increasing competition from US Treasuries could crowd out credit. However, in general, fundamentals remain solid, especially for corporates, so there is no cause for undue panic and a scenario of gradually rising spreads offers opportunities for us to find value in those pockets of the market that reprice to more attractive levels.

Guests

We would like to thank the guests who contributed to this new quarterly outlook with their valuable presentations and discussions. The views of Torsten Slok (Deutsche Bank), Shobhit Gupta (Barclays), Guy Stear (Societe Generale) and Rikkert Scholten (Robeco) have been taken into account in establishing our credit views.

By Sander Bus, Co-head Credit team, and Victor Verberk, Co-head Credit team

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