- by Suki Mann
|MARKET CLOSE 2019:|
|🇩🇪 10 Yr Bund
|iBoxx Corp IG
|iBoxx Corp HY
|🇺🇸 10 Yr US T-Bond
|🇬🇧 FTSE 100 6049.62, (-1.73%)||🇩🇪 DAX 12489.46, (-0.04%)||🇺🇸 S&P 500 3152.05, (-0.65%)|
There’s some skin left in the game…
It won’t be as exciting in 2020, not least because we will not be looking at 15%+ credit returns from AT1 debt markets, or even close to the 10.7% we saw in high yield – or upwards of 6% in IG. Nor will we be looking at record issuance levels from the IG and HY market. We’re going back to a more normal climate for corporate bond markets. Corporate bonds are meant to be a boring investment: You know? Buy the bond, clip the coupon, get money back at maturity, invest in the next issue. Welcome 2020.
We should get support for the market from lower levels of IG issuance (-15% versus 2019’s record €320bn), stable to quite likely improving macro and the ECB’s QE related corporate bond purchases. There will be an element of investors being crowded out of IG by the ECB’s manipulative hand (aka 2017), while adding high yield risk as rates (and defaults) remain low for an extended period.
We should be thinking in terms of a little above 1% of total returns in IG – unspectacular (granted!), but the grind tighter will also mean IG spreads are going to close in on their record tights (iBoxx). We could see returns of up to 4% in high yield as a strong bid for higher-yielding paper is sustained through the year. Subordinated debt will be an outperformer again.
So take some risk. We would suggest taking an excess beta portfolio positioning and set up for compression between IG and HY markets (overweighting subordinated debt – both financial and non-financial).
Data Source: Markit, CMD
|2019 (Actual)||2020 (Forecasts)|
|IG corporate spreads||B+104bp (-68bp)||B+85bp|
|HY corporate spreads||B+345bp (-178bp)||B+295bp|
|IG non-fin corporate supply||€318bn||€275bn|
|HY corporate supply||€76bn||€75bn – €80bn|
|Senior bank supply||€164bn||€165bn|
|10-year Bund yield||-0.19%||-0.20%|
|IG corporate bond returns||+6.3%||+1% – 1.2%|
|HY corporate bond returns||+10.7%||+3.5% – 4%|
Records went in US equities as the S&P rose by almost 29% in 2019. The Dax wasn’t far behind and whilst the FTSE was up only 10% this year in comparison, it could be the ‘go-to’ equity market in 2020 after Boris Johnson got his working majority following the UK election. An orderly Brexit at the end of January is nailed on and funds are likely going to pile back into UK equities.
A late squeeze, coming in December courtesy of a ‘phase 1’ trade deal between the US and China as well as that majority return for the UK government in the Brexit-election helped push credit returns significantly higher.
That late push helped add to performance in credit, such that IG credit made 6.3%, HY credit 10.7% – and the AT1 market some 15.8% on tightening of 312bp (all iBoxx) for the year. In addition, in the UK, the sterling corporate bond market, already in good shape before the election, tightened some more and this longer-duration market returned 10.8% in 2019 for investors. And Eurozone rates? Total returns fell through the final quarter – from as high as 10% as rates sold off, but still delivered 6.7%. Fantastic!
Credit index followed the trend. Protection costs plummeted in 2019, with iTraxx Main tightening by 45bp to 44bp (notwithstanding modest index changes at the roll dates) and X-Over protection dropped by around 150bp to almost 200bp.
The primary market saw records smashed in IG and in HY. There was a late spurt of borrowing from high yield companies which took the total issuance for the year to over €76bn, while in IG, issuance busted through the €300bn barrier for the first time, to €318bn for the full-year.
It will be more of the same into the early part of 2020, at least. As those credit strategy calls and decisions are made, we think there is little reason to change anything. It’s not going to be anywhere near as good as it was in 2019, but staying slightly long portfolio duration and overweight credit beta (and financials) will generate decent positive returns for the asset class.
We would overweight triple Bs vs single As and overweight single Bs versus double Bs – and overweight AT1 versus HY will still work. IG looks rich, as does corporate hybrid debt – but these two categories have a natural bid from investors and we would anticipate stable markets here, albeit with a tightening bias which sees index spreads for IG close to record tights, by year-end.
Macro to stabilise
According to the IMF, we should look forward to a modest acceleration in global macro through 2020 to around 3.4%, from 3.0% in 2019. The IMF points out that any recovery will not necessarily be synchronised and will be precarious. We think that’s less of an argument now, given that some of the headwinds appear to have fallen away, although we closed 2019 with a particularly poor set of manufacturing data for December from the Eurozone.
However, the IMF’s forecasts for an increase in the global number comes courtesy of an acceleration in emerging markets (3.9% in 2019 to 4.6% in 2020) against a slowdown to 1.7% in developed markets (in 2019 and 2020).
The manufacturing sector (auto sector weakness in Germany, for example, and reductions in global trade otherwise) is obviously the biggest contributor to the slowdown with weakness likely to persist through the first half of 2020, while the service sector across the globe keeps labour markets buoyant and wage growth healthy. Spillover from weak manufacturing has yet to be felt in the service sector, or at least seems to have been contained.
Further additional monetary stimulus is unlikely (see below) – or limited – which might serve to put the brakes on upward momentum in global growth, just as any central bank stimulus effects are having a declining impact on boosting activity, anyway. Nevertheless, monetary conditions are accommodative and will stay that way. The loss of momentum in German and French manufacturing in December will be a cause for concern during H1 2020.
So we would think that the US will grow by around 2% – 2.3% in 2020 and the Eurozone in the 1.0% – 1.2% zone. The former is a difficult one to judge but we could expect a modest push to the upside on the back of the ‘phase 1’ US-China trade agreement being signed, while consumer spending should remain at healthier levels as wage growth improves. We find it difficult to be as positive on the Eurozone as broader political uncertainties and the auto industry’s readjustment might be a material impediment for a recovery.
As at the time of writing, the risks are probably evenly balanced given the stabilisation in activity towards the end of Q4, hopes of a more robust trade agreement between the US and China and that election result in the UK. That is offset by the weakness in manufacturing still clearly evident across the Eurozone, especially coming after some poor manufacturing data as we closed 2019.
The ECB’s forecasts are more cautious and we would think a little more realistic (and still perhaps optimistic) versus the IMF, looking for 1.1% Eurozone growth in 2020 (1.2% in 2019), before projecting annual growth of 1.4% for both 2021 and 2022.
Inflation expectations see the US rate up at 2% (IMF) which looks a bit on the high side, although in the Eurozone, the ECB’s projections are a bit more cautious. They look for HICP inflation of 1.1% in 2020 (1.2% in 2019) before it rises to 1.4% in 2021 and 1.6% in 2022. The ECB has a habit of overestimating inflation expectations, we think, and we would caution to the downside risks.
Rates’ tunnel vision
Macro tail risks in some cases are receding and might help boost confidence in macro, such that the bid for safe-havens could be less evident. Nevertheless, there is enough to be concerned about that we think the moves in rates will remain limited and probably disjointed across the various jurisdictions. Because the risks do remain (see below), we don’t envisage a resurgent macro environment and so little prospect that market yields are pushed materially higher. Policy rates will barely move.
According to the Fed, policy is on hold and appropriate for the foreseeable future. We think that the Fed will stay pat on rates for all of next year – of course as will the ECB, but we don’t anticipate a material sell-off in euro rate markets (higher yields). There will be enough concern around the industrial sector, with global event risk headlines likely preventing significant government bond weakness. We’re not convinced that we are going to see a material improvement in growth dynamics for the region in 2020.
The Brexit situation now solved (with the Conservative party winning that massive majority) probably supports a shorter duration stance in Gilts, given that we can expect higher spending through the year as Boris Johnson’s government turns on the spending taps, thus pushing yield higher. That said, much will eventually depend on sterling’s strength and non-UK growth dynamics affecting the domestic economy.
There is an upside bias to US inflation in 2020. We would think that there is nothing happening on that front in the Eurozone where inflation will remain stubbornly low, while in the UK, inflationary pressures will probably stay contained as sterling heads to $1.45. In the Eurozone, that inflation rate will remain settled well-below the 2% core target level.
Benchmark yields don’t move much higher, in our view. The pressure on yields will be limited – especially as central banks are unlikely going to act on policy rates. The 10-year benchmark yield in the US will possibly rise to 2.25% by the end of 2020 (1.92% currently).
We think that they will be barely moved in the Eurozone at -0.20% (currently at -0.19%), and expect further compression in spreads between the periphery and the core. The risk here is probably to the upside in yields (become less negative) especially if we start to see signs that the Eurozone economy has bottomed and there is an improvement in growth (data).
In the UK we think a rise in 10-year Gilt yields to 1.00% is likely (0.82% currently) by year-end, as the spending taps are turned on by the new administration. Economic weakness across the Eurozone might see more pressure on the policymakers to cut rates, but we think they will resist on those grounds. However, signs of a ‘hard-Brexit’ with trade on WTO terms becoming the likely outcome, then we think the BoE will be forced into action. That is, the clarity on policy rates, in the UK, won’t become evident until into the second half.
It’s tempting to believe that we’re out of the woods. After all, we go into the new year hoping as always that global growth will recover as the year progresses. Apart from that poor Eurozone manufacturing print for December, we have ended the year on a positive note. Trade tensions have receded as that ‘phase 1’ US-China trade deal has been signed. Boris Johnson got his massive majority in the UK election and we look forward to an orderly Brexit. Interest rates are low and policy rates are forecast to remain unchanged through 2020 – and risk markets have reacted with prices lurching higher.
Plenty of political problems remain across the Eurozone – let alone the US, as those impeachment proceedings were enacted against the President. For example, Macron remains under severe pressure domestically, Merkel’s coalition is hanging on by its fingertips and, in Italy, there is always downside risks and another election is always just around the corner.
Structural economic uncertainties persist, especially in the Eurozone. The ECB’s new chief will be nailing her colours to the fiscal expansion mast – which will likely be resisted by governments and the markets, and a recovery in growth always seems difficult to envisage. The engine for that, Germany, is likely not going to offer much help as the all-important auto industry struggles under the weight of the diesel emissions scandal, climate issues and that shift towards electric cars.
Interestingly, the US has, almost in isolation, punched above its weight even with those global headwinds. Nor has the US helped the global economy perform better – which in itself is quite unusual. Can the US continue to grow at current or slightly higher levels through 2020, an important election year? It’s likely that it can, but the impact on global macro might be just as limited as it was in 2019.
Global macro has become less globalised.
Can we discount a deeper slowdown in China? They will get the benefit of the doubt for now. Of course, the reduction in trade tensions will give renewed hope that growth will tick higher. But we have continued uncertainties in Hong Kong, while few will bet the house on Trump playing ball throughout the year. The economy has long been dependent on short-term stimulus and, at some stage, they will run out of road. It might not be in 2020, admittedly.
We do think that a ‘cliff-risk’ event is unlikely. The authorities have done phenomenally well to manage that since the financial crisis began, but we are likely stuck in a low growth, low momentum global economy where the ability to manage downside risks is more apparent in China and the US. The Eurozone looks stuck with immediate economic risks to the downside – until deep, multi-year structural changes are enacted. And we know that is unlikely.
That cliff-risk issue isn’t completely ruled out. Because we might get some market jitters into Q4 dependent on how the UK/EU trade talks play out. The UK will pass a law ruling out extending the transition period beyond 2020. Although it can be amended, the change to the Withdrawal Bill to prevent an extension is designed to hold the negotiators’ feet to the fire of that year-end deadline. A ‘no-deal’, hard-Brexit is not off the table.
Primary market on solid footing still
There is no doubt that the record €320bn of IG non-financial issuance in 2019, smashing the previous record by a huge margin (2017, €275bn), was driven by the €100bn of deal flow from US borrowers. It’s clearly too early to suggest that this might the beginning of a more secular move which sees 30% of the market cornered by US-domiciled borrowers.
But we think that the ‘yanks’ will be in partial retreat in 2020. That’s because, in the large part, it was a case of ‘job done’, but the euro-denominated debt markets will remain an opportunistic port of call for reverse yankee offerings – and deals will continue to meet with a very receptive European investor.
Much of the deal flow from US borrowers was in large part M&A related but we think the 30% level of total non-financial borrowing is unlikely to be met within 2020 in the same size. The previous long term average was in the 12-18% area. However, the differential and directionality in dollar/euro interest rates, as well as untapped demand from European investors, could see the euro-denominated issuance proportion from US borrowers rise to the 20-25% area of the total over the medium term.
US Borrowers as a % of Total IG Issuance
Our forecast is that gross IG non-financial issuance will fall back in 2020 versus 2019 to around the €275bn area. That will represent a decline of around 15% from 2019’s record total. To us, that seems like a reasonable expectation. In addition to the boost from reverse yankee offerings, some of 2019’s issuance would have been delayed from 2018. Increased market volatility had curtailed issuance that year to just €220bn – which was the lowest annual level of IG non-financial corporate bond deals since 2012.
In the high yield market we think the final total in 2020 will be close to the 2019 total, or even in excess of it, thus possibly seeing a new record. As we closed out 2019, we are just about at the record level of issuance seen for any year since 2017’s €75bn, with €76bn issued. In addition next year, there is a funding wall that needs to be refinanced and might take the 2020 issuance level to between €75bn – €80bn.
There are also going to be higher levels of demand for HY product from ‘IG investors’ frustratingly forced down the curve, squeezed in their market by the ECB’s QE purchases. Macro (as ever) will matter and we will need market volatility to play ball as the market in Europe has a habit of completely closing in periods of stress.
Right now, the US economy is holding up relatively well, with Q3 GDP exceeding expectations at 2.1%. We might get a trade deal to evolve further – in due course, past the ‘phase one’ deal. The ECB will be a nuisance for IG investors however, sucking up additional liquidity through their participation in the IG – much as they did in the 2016-2018 period. That could bode well for the high yield market.
So if the US economy doesn’t fall off a cliff (in an election year), underlying market yields stay at around these levels and importantly, the default rate in Europe holds steady at around the 2-2.5% level, then we could be looking at a high level of issuance for 2020. That is, potentially, another record year is on the cards.
In the senior bank market, we have had an excellent 2019 and issuance surprised to the upside with €164bn printed, the best year since 2015. Eurozone macro is unlikely going to surprise to the upside by much, while loan growth and investment opportunities will remain sluggish. We believe that issuance for 2020 will remain flattish to the 2019 level, and therefore we look for around €165bn of senior bank issuance in 2020.
Positioning/Spreads: How to spend it
Fortune will favour the brave in 2020. Spreads and total returns are going to offer much less this year than in 2019. However, the broader market is going to remain fairly well supported from both a fundamental and technical perspective.
We are not going to see any material outflows from the asset class. Of course, some inflows will be looking for the kind of performance seen in 2019, but most of the redemptions will be reinvested looking for that safe-haven investment. Headline and event risk is unlikely going to be much different from that of 2019.
So from a fundamental perspective, we are in the first instance looking at a low growth macroeconomic environment. The Eurozone will fail to perk up by much as Germany enters a recession. That will act as a drag on Europe as a whole. the hope will be for improvement in Eurozone growth through H2.
Rates are unlikely going to rise. Policy will remain accommodative through the year. The default rate will not jump materially higher even as transmission risks increase a touch.
The high yield market might hold the key for investors in 2020, in terms of performance, anyway. Growth and default rates will stay at low levels, supported by the low market rate environment and accommodative policy stance. In fact, we don’t expect the environment for high yield market investors to change much, except that the entry point for investors is richer.
The demand side of the HY market remains intact, in our view, with European retail, insurance and crowded out IG investors all retain an interest in the market.
Euro-denominated credit spreads tightened by ca.70bp in IG in 2019, way in excess of most expectations when we started the year. With the iBoxx index starting the year at around B+104bp, our forecast is for spreads to tighten by a more modest 10-15bp in comparison, offering up total returns of around 1% – 1.2% for the asset class. The record low spread on the index is B+82bp. Financials will outperform non-financials.
In sterling credit, the iBoxx index tightened by 53bp to G+137bp. For 2020, we look for the favourable view of sterling corporate bond risk (Brexit, stable government, higher government spending) to be maintained and the market to tighten by 20bp, with the index tighter at around the G+115bp level by year-end.
The support for spreads will come from several areas. Global macro is not about to fall off a cliff, but we will need to navigate a lower growth trajectory through the year. The default rate will stay low (around 2%) though, as the corporate sector has largely managed over the past few years) to term out maturing obligations. And has also managed to hoard plenty of balance sheet cash.
Low rates have allowed the corporate sector much room and a comfortable buffer with which to service its obligations. While the rating transmission risks might deteriorate some more (more rating downgrades than upgrades), there ought to be very little which offers concern. The ability for companies to service their obligations remains supportive through 2020, in our view.
Thus for the high yield market, relook for spreads to tighten (iBoxx index) by 50bp – against almost 180bp in 2019) – but we should still see total returns in the 3.5% – 4% area, which is around the long term average for the asset class.
The ECB is back in the game, too. The average monthly haul though the purchase programme will probably come in at around €4bn per month and this will help keep the lid on spreads widening, curtail volatility and of some comfort to investors that IG markets might offer steady performance in a possible transition year.
Inflows into the asset class will wane – eventually. We think in Q1 they will remain fairly robust as they chase 2019’s performance, but they will decline as the year progresses as performance fails to match up to lofty expectations. Still, outflows will also be very limited and the ECB’s big pockets will come into play to help preserve performance. The retail and insurance bid will continue to support the market.
Even though we forecast IG issuance to decline by 15% in 2020 versus the record seen in 2019, we still expect it to be a high level. The same goes for high yield where we could be flat versus 2019’s record amount of supply. Potentially lower issuance dynamics, therefore, offers modest support for spread markets.
We again look for some further compression between the high yield and IG markets. The respective iBoxx indices compressed by almost 200bp in 2019. In 2020, we think that will be more like 30bp – 40bp in 2020. We also continue to prefer lower-rated risk versus high rated and would overweight triple-Bs versus single-A risk and be extremely selective in overweights of single-Bs versus double B corporate bonds.
The trade for 2019 was AT1 exposure. That continues in our view in 2020, especially if the banking sector’s recovery continues – albeit without delivering the 15% in total returns the AT1 market did last year. We also think that spread tightening in IG non-financials will underperform higher spreads offered in financials (senior and subordinated) and would run a strategy expecting financials to outperform.
So stay overweight subordinated financials versus senior, and while it does look as if the non-financial corporate hybrid market is rich, it is worth a slightly overweight stance. We dare believe the bid for the latter will remain solid, but the non-financial corporate hybrid market is unlikely going to significantly outperform.
Rates are going to remain anchored. We forecast the 10-year Bund yield will end the year at -0.20%, for example. Thus we don’t think that there is much risk from rising rates. Hence we would have a small overweight bias in credit duration.
US credit might be more attractive versus a richer euro market for those who can buy US dollar-denominated credit risk. We suggest otherwise compensating by adding greater euro single-B/BB paper.
… and in a nutshell
Risk asset prices didn’t rally hard in 2019 because of the economy – liquidity and the promise of more if necessary was the driver. And it turned out that 2019 was a great year for fixed income investors. In 2020 it will be back to normal.
However, we continue to believe that the corporate bond market will retain a good level of interest and solid support from investors. We believe that both fundamentals and technicals are going support a corporate bond market although that will deliver lower, (long term) average-like performance which, after the incredible performance in 2019, is not going to be scoffed at.
We’re not bullish macro and think it isn’t going to recover in any meaningful way. But that will offer comfort to the market in a ‘more of the same’ kind of way. We don’t need to fear a sudden ratchet higher in growth, soaraway inflation and significant currency adjustments. That said, the risks to global macro are probably to the upside, especially now that we have a ‘phase 1’ US-China trade deal reducing tensions. Further, we have reduced uncertainty on Brexit (in H1 anyway) while global central bank policy is expected to remain accommodative throughout the whole year.
So with the ECB effectively providing a back-stop bid for the markets (various QE purchase programmes), we continue to believe that investors should position portfolios for the highest excess beta reasonably allowed.
IG spreads, as measured by the iBoxx index, should tighten by 15bp+ and leave the index close to – or at – record tights by year-end. The HY index should tighten by 50bp as we look for compression between the two asset classes to continue. Financials will be the outperforms again, and we would favour subordinated debt.
Performance will be gained by overweighting financials versus non-financials, and subordinated financials versus senior. AT1 risk will again have another good year. We like single-B risk versus double-B and triple-B versus single-A, and while corporate hybrid risks look rich – there is likely going to be some further price upside to the asset class as investors clip any incremental yield available.
Wishing all our readers a happy and prosperous 2020.