- by Suki Mann
|🇩🇪 10 Yr Bund
|iBoxx Corp IG
|iBoxx Corp HY
|🇺🇸 10 Yr US T-Bond
|🇬🇧 FTSE 100 7344.92, -11.50||🇩🇪 DAX 12468.01, -0.25||🇺🇸 S&P 500 3006.79, +0.35|
The good, the bad and the downright ugly…
Greetings for 2019. We’re going be looking at one the most exciting years for a while. That there’s no hiding from the fact that it promises to be just as difficult as last year, riddled with as much – if not greater levels of – uncertainty, and we’re going to need to be on our toes right through it. That’s because many of 2018’s situations will continue to play out this year. Be that the real more material impact of the central bank tightening cycle, tense Sino/US relations and the impact of those trade tariffs, a raft of geopolitical event risks, the various developing friction between the sovereign states of the EU and the establishment, and Brexit. Oh yes, then there’s President Trump.
In 2018 we lost ugly in equities, it was bad in credit and commodities, while (Eurozone especially) rates were the good in performance terms. The Dax lost 18%, the S&P recovered to close around 6% lower (had been a stunning 12% YTD loss just before Christmas), euro IG credit returned -1.2% and euro high yield -3.6%. Brent was down $13 per barrel while Eurozone rate total returns were alone in the black at +0.9%.
The year might have ended in rollercoaster fashion for equities but it was with maximum turmoil. And nearly all of the issues came from the White House generated turmoil. All eyes will remain focused here. In the thick of it all was Trump. In no particular order, we had a partial shut down of the government as Trump battled the Democrats for ‘wall’ funding.
Trump’s foreign policy antics infuriated the US’s global military defence allies, while he was aiming fire at the Fed (speculation he wanted to fire Fed chairman Powell) irritated by their hawkish rate move in December. If ever there was a need to calm the markets amid some serious losses, Treasury Secretary Mnuchin took the rather unusual – rather mis-timed, almost rookie-esque, step to assure us about the banking sector’s liquidity!
Heightened levels of macro and geopolitical unpredictability are going to make sure that markets remain on the defensive from early on. Investors won’t be able to sit on their hands for too long (they’re not paid to) and will need to get money to work which will see some difficult investment decisions needing to be made. Levels of desperation will heighten if those volatile market conditions play out as planned and they are going to test everyone, in all the different asset classes.
The ECB is out of the fixed income game save for the sizeable reinvestment of maturing QE bond proceeds, so the level of market manipulation will be reduced and, indeed, unwound. The uncertainty is how it will impact fixed income pricing and levels, given that we are heading into an economic slowdown. Rates, therefore, ought to retain a better bid. Credit should come under some spread pressure, but the flip side of that is with Bund yields at such low levels, does credit offer a decent enough of a pick-up amid the potential for declining corporate creditworthiness?
Credit will likely see higher levels of single name event risk, and rating transmission risks might eat into sentiment as well. But the default rate stays low – and lower than this stage of the economic cycle than we might normally see. Outflows will depend on the prevailing view from multi-asset investors as to the relative attractiveness of equities versus a need to stay defensive and/or clip coupon.
For sure, some of the levels in price/yield/spread as we start 2019 look fantastic. We have had some serious levels of retrenchment in that triumvirate in high beta risk – CoCos have taken it on the chin, the high yield market has too, while single name event risk as well as primary repricing certain IG non-financial corporate sectors leave us with some potentially good entry points.
It’s kind of ‘all over’
The hugely difficult quarter for the corporate bond market with which we closed 2018 that led to a significant deterioration in performance will continue through the opening quarter of 2019, and most likely longer. The stage is set for a quite sombre opening period, and investors and borrowers will be tinged with a fear that we might just gap wider given the numerous event risk situations which lurk.
Credit recorded its worst year since 2008, when IG back then lost 4% and the high yield market returned -33%, while the HY market lost just 3% in 2011 as the Greek crisis erupted.
Over the last few years, the corporate bond market’s low hanging fruit has been picked and gorged on. Bloated on it, it was payback time in 2018. Now, we don’t see how credit spreads can tighten this year. But it won’t be as bad as some might fear. Returns should be positive at least.
We anticipate just a moderate 15bp of widening in euro-denominated IG cash spreads as measured by the iBoxx corporate bond index in 2019. That will take us close to B+200bp for this index, which was at B+97bp when we started 2018.
There will be demand for corporate bonds but many will fret how the economic slowdown might impact the asset class. As suggested earlier, the default rate will rise but stay lower than we might be used to for this stage of the cycle. M&A in a transformational sense will remain absent and we think corporates will retain conservative investment strategies as they preserve balance sheet integrity.
Data Source: Markit, CMD
|2018 (Actual)||2019 (Forecasts)|
|IG corporate spreads||B+172bp (+76bp)||B+190bp|
|HY corporate spreads||B+524bp (+238bp)||B+580bp|
|IG non-fin corporate supply||€220bn||€200bn|
|HY corporate supply||€62bn||€45bn|
|Senior bank supply||€130bn||€110bn|
|10-year Bund yield||0.24%||0.30%|
|IG corporate bond returns||-1.2%||+0.75 – 0.9%|
|HY corporate bond returns||-3.6%||+2.9%|
In the high yield market, we have lost any feel-good factor that the asset class might have had. The ECB’s participation in the bond market squeezing out of investors in IG, and then which pushed those investors towards the high yield market will no longer be a supportive factor. The level of rates might attract a crowd, however. We look for circa. 50bp of widening in the iBoxx high yield index which will take it to around B+580bp. The days when this market was setting records in spreads, supply and investor participation are long over.
As for returns, we can still garner a positive result, because we don’t think we will see too much of a sell-off in the underlying (government bonds). We think that IG credit (iBoxx index) should see us home with a 0.75 – 0.9% positive result. The shorter duration high yield market will also deliver a positive total return, and we are thinking somewhere in the context of +2.9%.
There is going to be a lot of uncertainty. The risks are big impact. A recession in the Eurozone doesn’t necessarily leave credit hanging by a thread. After all, balance sheets are awash with liquidity and while we might see some rating action, the ability for corporates to service their obligations is still very good.
Policy rates are unlikely going to be heading higher and markets rates are most likely going to stay anchored. The returns there are minimal, so credit offers that pick up for those investing for higher returns in fixed income. Credit should be offered some support as a result.
The economic cycle has come and gone, and we haven’t really seen a boom or bust! In the traditional sense, that is. How the cycle plays out now is anyone’s guess. The year’s of manipulation by central bank QE has had a severe distorting impact such that classic economics don’t apply. That is, we’ve barely recovered and we’re into a down leg, while the effect of further accommodation will be reduced. Credit markets will need to stand by themselves.
The first quarter will also see markets needing to handle the Brexit situation. It looks like the EU is playing hardball as evidenced by the EU’s no-deal preparations which were followed by some fairly aggressive language. That is going to investors on the back foot and apprehensive. Primary activity will therefore come and go and the ‘fits-and-starts’ like action in that market is hardly going to engender much confidence in the asset class as new issue premier will remain elevated (meaning much secondary repricing risk).
In all, we must be looking at some weakness in credit markets but hope that it can be contained. Entry levels look much more attractive than they have for several years. With rates most likely anchored and defaults set to remain at low levels, corporate bonds hold an attraction.
It leaves investors facing the delicate decision as to how to position. Improved entry levels mean that an overly aggressive bias towards higher beta positioning might not be warranted. After all, the level of macro and geopolitical uncertainty is sure to inject high levels volatility into markets and high yield/CoCo markets would suffer more than most. They already endured a torrid time in 2018, but 8% yield on SIFI AT1 debt, for example, looks too good an opportunity to miss. The financial system appears sound, but we can expect some single name event risk ala Deutsche Bank through the year. Proceed with extreme caution.
Primary market at mercy of external events
We must be looking at primary markets failing to deliver the heady levels of supply we were used to in the 2014 – 2017 period, which saw an average annual print of around €260bn in IG non-financial markets. Last year, we failed to keep up with the pace and managed just €220bn as the primary window opened and closed all too often. Volatile equity markets, widening spreads albeit as we had a year-end rally in rates all worked against any hopes that we might have achieved that €260bn.
Admittedly, we had some big deals. if it wasn’t for the likes of VW, Takeda and SAP late on, we would have struggled to reach the €200bn barrier. The window shut too often, opened and allowed the odd borrower through, before closing promptly. It was hardly a welcoming market in that sense and few borrowers could be convinced to ‘have a go’ as a result.
With macro and geopolitics set to remain as difficult in 2019, we don’t think even the €220bn will be possible in IG non-financial issuance. We are pitching up at €200bn for IG corporate issuance. The demand for more will be there, but we think that there will be too much ‘other stuff’ going on and that will cap the deal flow. And if the situation gets difficult, and more desperate borrowing will again come with massive new issue premier meaning secondaries will reprice. Investors will be apprehensive.
We might have had zero issuance in high yield in December and just €1.8bn in November, but we still managed €62bn for the full year in 2018. Coming home on the heels of that record supply in 2017 of €75bn, the year was a good one nevertheless. So as we head into 2019, our view is that we will see just €45bn of deals in the high yield market. That’s back to the pre-ECB QE non-manipulated level. It won’t bring too many problems in a refinancing aspect, because the wall of funding has been pushed back a few years.
Senior financial issuance is also set to decline. We’re going to see another record low being set in the deal flow. Last year saw just €130bn of issuance, and we think 2019 senior issuance will come in at just €110bn.
The economic cycle, (not) as we know it
We closed 2018 looking to protect performance and endured a torrid final quarter as we tried. Growth levels across global macro peaked at lower levels than we had been used to in previous cycles. We barely left the last downturn with a consumption, debt binge fueled M&A and investment-led overheating of the global economy. We did have a Goldilocks-like economic situation for several years, but that’s all.
The path of least resistance it seems is for weakness in risk asset prices. The current economic cycle has turned into its down leg with us reaching around half of the level of previous peaks in GDP growth. We are still, that is, feeling the ramifications of the 2008 financial collapse. A decade on, and with no clear out or clean up of those past excesses, we are set for the period a low/weak/poor economic growth to continue. All we have managed in the meantime has been to increase the overall burden with low rates enabling us to service that indebtedness.
The ECB will have to stay accommodative through rate policy for all of this year, as a minimum. We believe that the BoE also has its work cut out as it feels its way through the Brexit ramifications, as well as a general slowdown in activity. The US Federal Reserve has already suggested it will only move twice in 2019, although ongoing balance sheet unwinding is a tightening in policy.
Thus markets are running scared because we don’t know where the growth is coming from. The Chinese economy is slowing relatively hard and around 6% growth for 2019 won’t cut the mustard in terms of keeping global growth up at 3.5% or more. The bleak picture is especially so for Germany, the engine for growth for the Eurozone. It is being hit particularly hard and a messy Brexit coupled with a slowing China is going to drag the whole region down. Recession beckons.
New central bank QE is unlikely, though, unless any light we see at the end of the tunnel takes us head-on into a financial markets crash. We are just going to have to get used to low rates, low growth, hopefully slowing inflation and weaker earnings streams – for longer. Market levels are already adjusting.
This is not about needing additional stimulus just yet, it is about the need to work through those ills created on the back of easy money. No one has the political metal for it. The Eurozone might have spent the last decade shoring up the defences of its financial institutions, but it remains hugely ill-prepared for a ‘cold turkey’ moment.
That means corporate investment, capex and M&A activity will remain subdued. Those conservative corporate balance sheet postures which have been a feature of the crisis decade will remain in place a while longer. European corporate balance sheets are rammed full of cash after gorging on low-cost debt for years; they will be in mood to spend their booty into the prevailing uncertainty. They will need to hang on to it, especially as the Eurozone’s fragile economy is heading for a massive Brexit shock – most likely.
Rates to stay anchored
So 2018 turned out to be a shocker for all. The Fed’s move to a more dovish interest rate stance didn’t cut the mustard and resulted in a terrible December. Lowering rate hike predictions (to 2 from 3) for 2019 while warning on growth saw equities take a battering in that month. That 2,940 record level on the S&P in Q3/2018 seems like it was light years away. We’ve been through 2,500 since. The Dax lost around 18%!
It meant that safe haven assets came into focus. US Treasuries were bid up, the yield on the 10-year dropping to 2.76% and the equivalent maturity Bund yield was anchored at around 0.23%. 2018 predictions that the 10-year Treasury yield would rise to 3.25% and the Bund yield would come in at 1% at year-end missed by some margin. It now likely we won’t even see us at that level come the end of 2019.
The flattening of the 2s/10s (although stepper at the time of writing) is classically suggesting an impending recession in the US. A curve inversion has preceded every US recession since the second world war. Recent factory data from the US is indicative of some sort of slowdown in the works. And just as inflation (expectations) likely start to wane too. There’s a lot of water to pass under the bridge but 3%+ on 10-year US rates for the end of 2019 looks a stretch from here. The Fed will cut quickly if it needs to – it has form on doing this after all, while the two hikes pencilled in for 2019 might need to be rubbed out.
It’s difficult to get bearish on European rate markets too. We are slowing on macro and its likely that the region is going into recession. That means inflation will fall short of the ECB’s policy remit, and policy accommodation might be required again. It doesn’t necessarily mean more – or rather a resumption of – QE. On a scenario analysis, we think that the risks are front-end loaded, so we will likely see choppy equities, weakness in spreads and a better bid for safe-havens (government bonds). Subsequent policy response as central banks react to the doom will come after. As usual, they will be behind the curve, and if effective, we have a reversal of the above into the latter stages of 2019.
We would probably be looking at Bund yields in the 10-year area to rise at most to 0.40% by year-end in the absolute most bullish case where growth surprises to the upside. But we are more likely going to see a yield of 0% on the 10-year before we go past 0.30%. Our year-end target is 0.30%.
Gilt markets are going to be as unpredictable. As well as the global slowdown, the BoE will be on Brexit-watch through the first quarter definitely, and most likely beyond. A ‘no-deal’ outcome will likely have them cut rates as the bank would see the need to provide stimulus into the massive uncertainty which would likely be unleashed. The yield on the benchmark 10-year Gilt could easily breach the 1% mark (1.25% now), a level last seen in 2017.
2018 was a shocker, 2019 can’t be as bad
In credit, IG spreads (iBoxx cash index) widened by 75bp and total returns were -1.2% for the year. In sterling, the longer duration market saw index spreads widen by 59bp with returns of -2.1%. The high yield market lost 3.6% after a late sell-off as equities collapsed saw iBoxx HY cash index spreads widen eventually by 230bp in the year.
These credit market performance numbers need some perspective and look reasonably encouraging when stacked up against the performance of equity markets. Nevertheless, credit went into ‘lock-down’ in Q4 where primary activity fell and investors pulled in their horns, meaning spread weakness was relatively contained, thus saving the market from an even worse fate.
Equities endured a torrid time. Dax lost over 2300 points, or 18% last year. The S&P, busy setting record levels at the end of Q3 – and up by 11% for the year at the time, subsequently sunk to losses of 6%. The Fed’s hawkish rate move in December lit the blue touch paper for a recession coming up in 2019 (look at the yield curve), the President locked horns with the Federal Reserve’s chairman, while separately the US defence secretary resigned.
In euro credit, we have a €2trn corporate bond market and we do not expect any material rotation away from it into say equities or government bonds. The former promises to be as volatile this year as it was in 2018, while rates are just yielding too little to be interesting enough. Therefore, credit has some lure and positioning within credit is going to be key.
Some might be licking their lips at the much-improved entry levels. But 2019 will be one of the most challenging years seen in a long time. We must remain wary because the risks are big impact which would a serious deterioration in risk asset pricing.
For 2019, We look for weakness but we are by no means overly bearish spread product. We are looking at spreads to widen by 15bp, 10bp and 50bp for the euro/sterling/high yield markets, respectively. Total returns should be in the black if the underlying remains anchored at around current levels – as we anticipate. That ought to leave euro IG returns of between +0.75% – 0.9%. As for the high yield market, there should be enough there for the sector to generate returns of around +2.5% – 2.9%.
We’re likely needing a more sophisticated approach in terms of positioning following a decade-long spree of buying the highest beta product one’s portfolio allows and running with it. It is going to be a little more delicate in 2019, which likely represents an inflexion year for the corporate bond market. Hoping for the best, we are basing our positioning in the credit market being able to muddle through the various risks presented to us – and absent a global financial crisis.
There will be a need for yield but with an eye of needing to play it safe. Improved entry points should keep the tourist investor engaged, but we’re late cycle and some sectors will be feeling the pinch (as they already did in 2018). There’s no CSPP (save for reinvestment) to cap spread widening, but we should start the year in defensive fashion.
Neutral credit, we would be underweighting financials and cyclical corporates and offsetting with an overweight in defensive corporates (non-cyclicals). That means underweighting autos, industrials retail and defence sectors – sectors which are typically cyclical and/or are maligned by higher levels of event risk.
We would offset that by overweighting non-cyclical sectors such as consumer, energy and pharma. The market weights take in senior financials predominately where we expect reduced levels of supply. There is likely going to be underperformance in financials, which may well come as a result of a severe downturn in macro while single name event risk might see some contagion across the AT1 market.
We would take our outright risk through curve and rating views. Insurers and pension funds will be attracted by the longer end of the curve and might be the big support for the market. Given we don’t believe long-end rates will rise by much, we would position with a bias for the 7-10 year part of the curve. The belly (5-7 year) would be a fallback position. In addition, we still like triple-Bs but we are not necessarily looking for any compression between As-BBBs, nor HY versus IG.
It won’t be great, but we believe that credit has a chance to perform relatively well once again versus other risk assets. We will start the year on the back foot once across the board though, amid a plethora of events largely of the making of the US domestic political scene. President Trump has been throwing his toys out of the proverbial pram at every opportunity, has now dug his heels in after shutting down part of the government as he demands that ‘wall funding’, will continue seeking to influence Fed policy, while his US foreign policy is verging on the isolationist (shambolic?) following the departure of his much-respected defence secretary.
Elsewhere, we will grapple with the Brexit situation where European macro could turn uglier as it faces an economic slowdown, just as the EU Commission looks to play hardball with the UK government. The timing could be good for the UK in terms of its ability to extract a trade deal as she seeks to potentially withhold the £39bn divorce payment. The Italians may have acquiesced on their 2019 budget proposals, but the situation there is very fluid. More drama will unfold.
In EM, it’s really all about Chinese macro amid fears that the Chinese economy has failed to react to previous stimulus measures. Annual GDP growth closer to 6% for the full-year 2019 versus say 6.5% looks likely – a rate for which there will be global macro repercussions.
So the opening quarter promises as much uncertainty with which we closed Q4 2018. Our credit expectation is for reduced levels of primary activity as we open, with spread direction dictated by the level of and volatility in equities. That will likely be for wider spreads and we might not get a good grip on how the year will play out until well into the second quarter. Staying defensive for starters makes sense. But there will be some compelling opportunities. He or she who dares might just win.
Wishing all our readers a happy and prosperous 2019.
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