1st September 2019

Stick or twist?

MARKET CLOSE:
iTraxx Main

48.8bp, +0.7bp

iTraxx X-Over

253bp, +0.7bp

🇩🇪 10 Yr Bund

-0.71%

iBoxx Corp IG

B+120.8bp, +0.7bp

iBoxx Corp HY

B+425bp, -1bp

🇺🇸 10 Yr US T-Bond

1.50%

🇬🇧 FTSE 100

7167.95, (-0.61%)
🇩🇪 DAX

12670.11, (+0.32%)
🇺🇸 S&P 500

2989.69, (-0.21%)

Politics and trade war whip up the perfect storm…

Much of it doesn’t make sense, but on we go – and into uncharted territory, so anything is possible. Politics and trade dominate the landscape, leaving macro on the precipice. Brexit, Italian politics, Hong Kong, US/China, Kashmir and Argentina’s default are all deserved of investors’ attention. The resulting and predictable equity volatility – particularly derived from the worsening US/China trade situation – has seen US markets fall from their record highs. The bigger story is in rates. The government bond rally has seen yields collapse in August, with curves flattening and/or inverting as markets position for the next round of central bank activity. It has seen Eurozone government bonds return 10.5% in 2019 so far!

The US Treasury curve has flattened or inverted across the various metrics, which would usually indicate that a recession is just around the corner. Further action is imminent from both the Fed and ECB as they try and avert more downside and recession. A (likely) negative GDP print in Q3 for Germany would signal a technical recession for her economy, while the 10-year Bund yield has plummeted in August – and by 28bp at one stage, to record a historic low of -0.728%.

Investors, though, are lording it from a performance perspective, especially in fixed income with returns heading for the moon. It’s great for 2019, but total return markets will resemble a dustbowl in 2020.

In the safest of haven debt markets (government bonds), where yields are embedded deep in negative territory, it has now become extremely difficult to envisage the process that sees a return to normality (positive yields). Thus negative yields – across entire sovereign curves – are something that we need to get used to. The traditional methods used to attack the malaise in macro and markets will likely fail in producing the desired results, in our view.

So as fresh blood (more liquidity) is injected courtesy of the ECB, those Bund yields – dare we say it – are heading lower. In credit, despite having backed-up in August amid high levels of equity volatility, we think that IG credit spreads will head into record territory. There is some way to go, but we can expect a ratchet tighter once the central bank announces its intentions next week.

The dot.com bubble went on what felt like forever and a day and we all have a feeling that this current ‘bubble’ will also possibly end badly. The markets are thus way overvalued, but have been for a long time. However, markets can be wrong for a lot longer than investors can. After that volatile August, with the trade war between the US and China moving up a serious notch, we could really do with some calming in the tensions and rhetoric.

Meanwhile, while it all continues to stir, we have been here before – and lower levels of market activity & investor participation through the summer weeks have (we believe) resulted in some exaggerated moves. As for the growing bubble, where else to invest all the liquidity that the central banks are generating?

In credit, around 40% of the euro-denominated IG corporate bond universe is offering negative yields. The dilemma for investors now is whether ‘real money’ buys negative yielding corporate debt to any great extent. If not, then longer tenors (or lower quality) become the modus operandi of the investment process. We’re going to chase it. We don’t really see a material widening in credit spreads as investors demand some sort of positive yield – the market isn’t disciplined enough for that to be the case.

On the other hand, the temptation for some will be to book some of the profits after generating 8%+ returns in IG, in the period to the end of August 2019. But where does that money go if one takes those profits – as they possibly wait for fund redemptions, apart from into cash?

Staying invested

We would think that investors will remain invested and enjoy the moment. Portfolio net asset values continue to rise as spreads tighten and yields continue to decline. Prices are going higher and it is that what matters. The yield is just a formula.

The broader market anticipates an ECB rate cut and QE at the 12 September meeting (we go for a 20bp cut and €15 – €30bn of monthly QE). We have long thought that the benchmark 10-year Bund yield was going to see -0.50% (it has) and that while -0.75% was going to be the next big headline figure to aim for, we think -1.0% is now a reasonable target for Q4 2019.

The knock-on impact has seen Spanish sovereign 10-year yields now just a handful of basis points away from falling into negative territory – the most incredible of feats when considering the whole of the periphery was a basket case as recently as 2012, and could barely fund in the markets at a reasonable level (if at all). The ECB won’t be too concerned and will just buy – while investors will front run the central bank, and we can expect to see the 10-year Bono yield drop through 0% very soon.

So we think that IG returns can top 10% this year, from their index gains of 7.4% year-to-date. The iBoxx IG corporate bond yield has crashed to just 0.43% (-119bp YTD) and we will be looking at 0.20% if that underlying rallies, as we have suggested it might. Spreads have widened this month but that is purely on the huge volatility in stocks (and probably some pushback on value given the yields on offer) amid little real volume and flows through the holiday weeks. We believe that they will resume their tightening.

Few are going to change strategy now.


Sluice gates open in primary

The markets opened with a flood of deals

In the meantime, and earlier than we expected, the markets reopened last week with a flourish and a gusto not seen since last year. Deals have flooded the market and 0% coupons have become a little more commonplace. Corporates are borrowing for free, rather being paid to borrow. Investors are looking at capital appreciation to boost their performance, (driven by spread tightening and/or lower yields) and are adding as portfolio cash needs to get invested.

In IG non-financials, the €20.4bn of issuance in August marks it as the best month for years and has taken the overall deal flow for the year to past the €200bn mark. If we continue at this run rate, then we are going to get close to breaking that 2009 record of €285bn for the full-year. There’s a good chance that might be the case given that any ECB action is going to drive the market to another level (tighter spreads, lower funding costs, increased performance).

The high yield market has been quiet, though. August barely broke a sweat, but we should be looking at a decent final third as we close the year, given where IG spread markets are. We’ve only had a billion printed in August.

Senior financial issuance at over €11bn for August was still behind 2018’s corresponding €13.6bn, even after that flurry of issuance in the last week of the month. For the year to the end of August, the €118.5bn has a good chance of seeing us over the line for the best year since 2016’s (€145bn).


Now is not the time to suffer from acrophobia

We closed out a busy week – and month – in primary with deals from Lufthansa and Solvay. The former managed a book in excess of 6x for the €500m, 5-year deal which was eventually priced at midswaps+85bp, but was 40bp inside the initial price talk. As for Solvay, the Belgium based group lifted an upsized €600m in a 10-year priced at midswaps+82bp (-28bp versus IPT), with book exceeding 4x. The other deal came from property group Fastighets AB Balder, in the form of a €600m long 7-year at midswaps+157bp.

With the US markets closed on Monday, it might give European markets time to take a breather ahead of what promises to be a volatile and difficult run into the end of the year.

During the month, though, IG credit spreads widened by 10bp (iBoxx index at B+120bp), but the massive rally in the underlying helped to boost returns (more in tomorrow’s daily). The corresponding HY index saw a widening of 16bp. However, the IG index closed the month having returned 0.6% and a whopping 7.7% in 2019.

The story in IG credit was around those 0% coupons – or rather the negative yields – with paper being snapped up by investors in primary (admittedly with some limited pushback). However, the 10-year Bund yield fell by 27bp in August to close the month at -0.71%, with similarly aggressive moves in other rate markets. The iBoxx Eurozone government bond index returned 2.5% in the month and is up 10.5% in 2019!

Against those excellent fixed income market performances, which we discuss more in Tuesday’s comment, equities had a more difficult time of it in August. An improved tone in the US/China trade spat of late helped to boost stocks into month end, but they still ended up to 3% lower.

The US markets might be closed on Monday for their Labor Day, but that doesn’t stop the new US tariff regime kicking-in on Chinese imports covering over $125bn of additional goods (from Sept 1). In the UK, we face the most crucial week in politics since the second world war, as Parliament returns to debate Brexit and proroguing. Hong Kong is still bubbling although there appears to be sense of calm returning for the moment. We close out the week with the non-farm payroll report.

These are exciting times! And we’re living through them. We all will have an incredible story to tell.

Have a good day.

Suki Mann

A 25-year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on Credit Market Daily.