Strong credit fundamentals, stable leverage, low default rates and high interest coverage, means that global fixed income markets are currently a profound shade of vanilla. So says Andrew Jackson, Head of Fixed Income at Hermes Investment Management, in his quarterly market update.
As a credit investor, my natural outlook is pessimistic to catastrophic. Despite all of my natural instincts, across the corporate world, balance sheets look robust, leverage is not imperiling companies and interest coverage ratios are good – even when likely interest-rate increases are taken into account. True, the financial state of the UK high street is ugly, but we do not think that its current wave of defaults and restructurings is a forerunner of the much-anticipated end of the credit cycle. We may have to wait longer before that happens.
As liquid credit curves have steepened, we prefer longer maturities. At the long end, there is an attractive combination of relative under-ownership, superior roll-down and convexity. In emerging market (EM) credit, our appetite is for investment grade over high yield. Since 2015, there has been a lack of dispersion risk priced in to EM high yield compared to EM investment-grade credit. As a result, we prefer investment-grade to high-yield EM issuers, particularly when the company demonstrates improving environmental, social and governance (ESG) fundamentals. At a regional level, the underperformance of Latin America on a year-to-date basis creates an opportunity for tactical allocation of capital to this region.
We have seen UK and European yield private debt premiums shrink due to stronger UK growth. There has also been a significant improvement in the UK mid-market M&A pipeline, causing pricing competition to fall and midmarket loans are now providing a yield premium of about 85-100bps relative to euro-denominated loans. The retail and hospitality sectors, which are currently experiencing some stress, remain a concern in the UK private debt market and this has led to a rise in loan defaults.
Not every cloud has a silver lining…
However, not every cloud in the vanilla skies has a silver lining; we believe that markets and investors have high levels of complacency about potential tail risks. Asset prices suggest that the probability and likely severity of any tail event are both incredibly low. I agree with the former, but cannot ignore the potential impact of unpredictable geopolitics and the rise of populism, protectionism and the possibility of trade wars, and the unknown impacts of normalising extreme monetary policies.
So far this year, economic data has been cautiously positive, with global growth now back at the levels that prevailed last year. However, the balance of risk is skewed to the downside: global growth has desynchronised, China’s economy is continuing to slow, protectionism is on the rise, and the risk of a global liquidity squeeze is growing.
Protectionism is the main risk clouding the growth outlook. China’s share of international trade now exceeds that of the US, making trade tensions between the two countries inevitable and a geopolitical risk going forward. The macro impact of measures announced so far is marginal, but a broad-based retaliation would have vicious consequences.
Central banks have been proficient in phase one of the QE unwind. In June, the ECB announced that, after September, it would reduce the monthly pace of net asset purchases subject to its inflation outlook at the end of the year. It also signalled that rates will remain at current levels at least until mid-2019. Credit markets interpreted this as a positive signal, given the clear visibility of low rates for longer. The US Federal Reserve and the ECB have also managed to provide clarity through forward guidance. This may be more difficult in the future and markets may, as a result, become more skittish.
Whilst overhead skies are vanilla, splashes of colour are on the horizon. Investors should not concern themselves with trying to predict the timing of when they will arrive, rather, they should proceed with one eye on the skies and prepare their fixed income portfolios for when they do.
Click to read the Hermes Fixed Income Quarterly Report in full.