18th January 2016

Why all is not lost

Guest author & fund manager Stephen Ronnie states the case for remaining positive.

The hope is always that the next year cannot be as bad as the previous one. Unfortunately, a fast and furious start to 2016 has quickly quashed much of the early-year optimism. The issues which are pressurising markets now are the ones that were at the root of market turmoil in 2015: China, emerging markets, low or rising interest rates, commodity market meltdown and tensions in the Middle East. These issues will remain with us through the short term and will even have a longer-lasting influence on the global economy – and in some cases its social fabric – further into the future.

With all these sources of volatility and the impression that all the easy trades that existed in the follow-on from the financial crisis have been done and are now looking stale, it is no wonder that people have continued to clamour for real assets. In the UK and parts of Europe, bricks and mortar have become the asset of choice, and larger investors have directed funds to infrastructure investments. And, perversely in this low or even negative interest-rate environment, money is being left in cash.

Aside from the cataclysmic gyrations caused by the larger themes, there were also subtle movements in 2015 which provide hints of things to come. For example, the saga around Abengoa, the Spanish infrastructure business. Despite numerous attempts to refinance the firm, its panel of banks were still willing to pull the plug on the company’s funding. We were sent a clear signal that banks are now in a position to bring to an end the era of ‘extend and pretend’.

VW’s over-eagerness to employ its “Vorsprung durch Technik” approach to hoodwinking the US regulators backfired. Though a quick fix to the problem in the German manufacturer’s domestic market has been agreed upon, the US is unwilling to settle for anything but a sack full of booty. While not wishing to condone VW’s actions, it is now clear after a series of incidents that there is a danger that at some stage non-US corporates or financial institutions are vulnerable to expensive US litigation risks. America is becoming a dear place to do business. When investing in issuers with a sizeable presence in the US market, perhaps a spread premium is warranted for this risk.

At the height of the euro crisis it was expedient to invest in issuers that had a diversified geographical spread of operations and were not dependent on their domestic markets. Developments in 2015 have to some extent questioned this approach. With a slowdown in emerging markets, global diversification cannot always be seen to be an ingredient of an issuer’s fundamental strength.

A marked reduction in the banking sector’s commitment to providing liquidity to the corporate bond market and the growth of the market itself – especially in Europe, where the asset class has transformed itself from a mouse into an elephant – are making position-setting difficult. We are now likely at the high point of the dissemination of corporate risk away from banks which began back with the first euro credit deals in 1999. Investors have been turned into bank managers as banks themselves have been busy repairing their balance sheets. In the trending markets we experienced in the immediate run-up to 2014, this was not a problem. The recovery trade or correct assessment of the large macro issues determined the path of the credit market. Last year marked the return to idiosyncratic risk and the necessity of knowing the issuers that are being invested in. With no easy exit for bad positions, investors have become welded to their positions, with the most efficient hedge being the issuer research done ahead of buying the bonds.

For a portfolio manager carrying last year’s baggage and with zero registered on the performance clock, what options are open in 2016? A first reaction would be to join the chorus of pessimists that see another financial market crisis zooming down the track towards us. As already mentioned, the issues that exist are large and will take time to be addressed, but there are reasons not to sink completely into a mire of negativity.  Active managers have their moment to show their worth versus non-active index products.

Ironically, an element of hope lies in the position that US corporates now find themselves in. They are running through their cyclical playbook. Working capital and operational improvements were made in the early stages of the recovery process, followed by share buybacks & increased dividends and rolling into M&A as the cycle matures. With leverage increased to unhealthy levels, US corporates are now going to have to focus on actually making their businesses work. A move away from corporate stagnation should provide a backdrop for the equity market to stabilise, which will in turn be a support for credit markets.

Banks seem to be the consensus trade of 2016. Although similar to US corporates but with the one difference, they have had their playbooks written for them, but they too have now reached a point where they will have to demonstrate their entrepreneurial skills and make money. While the quality of the instruments that are available for investment is debatable, there is a lot more visibility over the sector today than there has been for some time.

The macro situation in developed markets is not all doom and gloom either. The US has put clear water between itself and the financial crisis, and Europe is starting to show that this crisis is being pushed away. However, there is general agreement that growth will be low and the pace of recovery will be hampered by the headwinds already mentioned. There are also enough issuers with the investable population which have sound fundamentals and are in a position to weather economic and capital market volatility.

As CMD has pointed out, there are also transient opportunities such as the bonds of US issuers that issued in euros last year. This is in a similar vein to situations in the past where euro issuers that issued in USD saw their bonds become lonely when the US investor shied away from them.

With riskless assets being bought away from under investors’ feet, there remains little option for them but to turn to corporate bonds. The finger-burning events of last year might encourage a more conservative approach, especially in high yield. The question is what will happen when banks decide they want to lend again and start to take back some of the lending activity that has seeped into the credit markets in the time that they had shunned corporate lending?

So all the normal factors – rates, technicals and the overall macro landscape – will be important in steering the performance of the corporate asset class in 2016, but the main driver will be the selection of the issuers invested in. It is the corporates and financial institutions that will be sending the signals of where we stand in the development of the global economy or where we are in the recovery of developed economies. Until the next “great thing” comes along, we are going to have to put our faith in the managers of the issuers we invest in.

We have come into this back-up in risk markets ahead of the traditional early-year revving up of primary markets, so to a large extent the market is being choked by the troubled positions from last year. Until visibility clears on the existing key themes hanging over the market, it is better to avoid swinging the bat at the higher beta bonds and to look at issuers which are in a stable fundamental position but whose bond spreads have widened along with the rest of the market. These types of issuers will benefit from any relief rally but will not give up so much if the market weakens again. Again, as was the case in 2015, interest rate duration will be an important factor. Long duration is a cheap and liquid hedge when risk assets are selling off, and quick to whip off if the market moves to risk-on.

Clearly, how portfolio managers deal with a period of extreme moves depends on the hand they hold. If we assume that a fund had a neutral position at the start of this year, then I would personally maintain that position. Trying to sell in a market starved of liquidity is going to be difficult and expensive. Unless things change dramatically, I would maintain the neutral position and look to up the risk exposure going into autumn. All is not lost for 2016, but the recent events have pushed back any chances of a strong euro IG performance until the second half of the year.

Stephen Ronnie

Stephen has been managing Corporate Bond portfolios for the last 16 years, most recently for LGT Capital Partners and prior to that for Pimco. Previously, Stephen was associated with Lehman Brothers and Merrill Lynch where he worked in Fixed Income Sales and Trading.
The views expressed here are his own.