Outlook 2020: Global credit
- Corporate bond fundamentals remain moderately supportive on balance, but declining incrementally, with debt levels elevated but companies still able to meet repayments.
- 2019’s substantial returns are unlikely to be matched, but income should drive moderate gains with investors still having to reach for yield.
- We look for signs of lower growth or rising wage pressures squeezing corporate profit margins.
Bolstered by the dovish turn by global central banks and the reach for yield, global credit markets enjoyed a very strong year in terms of total returns. Both investment grade and high yield markets notched double-digit gains. Given this strength, it is difficult to imagine similar levels of returns in the coming year. We feel that with valuations so tight, returns will be modestly positive in 2020 and come primarily from coupons.
Cautiously optimistic on the economy
We are cautiously optimistic about 2020 amid signs that the US growth engine, consumption, is cooling. Consumer spending and retail sales, while healthy, have been moderating. Against this the manufacturing sector seems to be regaining some ground. Previous periods of “insurance cuts” by the Federal Reserve (Fed) have tended to halt slumps in manufacturing sentiment and this may be what is playing out now.
A key driver of this manufacturing weakness, the US-China trade conflict, appears headed in the right direction. While a full deal is unlikely near-term, the prospect of rapid escalation seems to be reduced. Another key systemic risk, Brexit, has also improved as the possibility that the UK crashes out of the European Union without a deal has been minimised.
Despite these positive signs, we remain cautious. A lot depends on the continued health of the US consumer. There is a risk that moderating growth results in thinning profit margins. Businesses could then cut jobs to reduce costs, putting pressure on wages and consumer spending. Stable profit margins have been supportive of credit markets, but this is something we will be monitoring.
The global geopolitical environment, in all likelihood, will continue to drive volatility in 2020. There is continued uncertainty in various parts of the world. In the US, it appears increasingly likely that President Trump will be impeached by the House of Representatives while the 2020 presidential election adds uncertainty.
There also continues to be uncertainty in Hong Kong SAR, Chile, Ecuador, Iran and the UK. These risks are contained for now, but they warrant caution.
We see US growth bottoming at 1.4-1.8% in 2020 as consumer spending and employment hold firm and worries of a manufacturing or investment driven recession prove too pessimistic. The Fed is unlikely to cut from here unless there is a material negative change, so Treasury yields could rise over the coming quarters.
Globally, we feel growth could rebound modestly, driven by thawing trade tensions and easier global financial conditions that will help emerging markets become a core contributor to global growth.
Credit fundamentals are moderately weaker
In aggregate, investment grade (IG) credit metrics have deteriorated. Leverage remains well above 2008 levels and is elevated for a non-recessionary environment. However, cash levels are healthy, which has kept net leverage below the 2001 peak and a large portion of this leveraging has occurred in non-cyclical sectors. Interest coverage has improved from the 2008 level.
While there has been some fundamental improvement in various low triple-B rated issuers, we believe that earnings growth, which has moderated in recent quarters, could remain weak. Our current view is that earnings would remain under pressure if we see margin deterioration. This deterioration could come from a “de-globalisation”, a slide in productivity or rising labour costs. Current estimates of an earnings rebound in 2020 look overly-optimistic.
In high yield credit too, leverage is above 2008 levels by a sizable margin with coverage slightly higher, but off cycle peaks. One difference is that HY companies are generally smaller and domestically-focused, so they are less exposed to the decline in globalisation.
Overall, we think deleveraging will become more difficult in both global IG and HY markets as rising labour costs squeeze margins and productivity. While coverage ratios are healthy, this reflects the fact that low yields have helped companies issue debt with longer maturities and significantly lower coupons.
Supply and demand conditions supportive
In IG, we expect net supply to be lower next year, which should be supportive. Issuance related to mergers and acquisitions (M&A) has slowed and many large issuers are focused more on reducing leverage as end-of-cycle fears become more prevalent. Additionally, the GSIBs (Global Systemically Important Banks) have reduced issuance for regulatory purposes, which we expect to continue.
In the HY market, we think supply will be flat. Factors driving higher levels of issuance, such as the percentage of call constrained bonds to be refinanced, are offset by cooling M&A activity amid global uncertainty.
We expect demand for global credit to remain strong. While off recent peaks, the market value of negative yielding debt is still at historic levels (see chart below). We think this will push investors to take more risk as they reach for yield compounded by lower rates and central bank balance sheet expansion. This will likely push investors into higher yielding areas, such as US dollar IG and HY.
Income to support more modest returns
We enter 2020 with credit spreads at fairly lofty levels. Both global IG and HY spreads remain just off cycle tights. Given the number of macroeconomic, geopolitical and fundamental risks, we think that a great deal of good news is priced in and see little room for further spread compression from here. Investors have already been reaching out the risk spectrum for the last several years, pushing spreads on both indexes tighter even in the context of a manufacturing recession, weak earnings and trade policy volatility.
While the reach for yield is likely to persist amid dovish central bank policy we remain cautious moving into 2020. In terms of returns, we expect a more muted year than 2019, with returns driven primarily by coupon or interest payments.
- You can read and watch more from our 2020 outlook series here
Risk associated with bond investing
A rise in interest rates generally causes bond prices to fall.
A decline in the financial health of an issuer could cause the value of its bonds to fall or become worthless.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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