Fixed Income

2019 Credit Insights: Do the Chinese zodiacs have it right?

As 2018 ended with some rather unsettling volatility, we juxtapose the zodiac symbols from one of credits’ main players, China, and look at what fixed income investors might expect, and might be surprised by, in 2019’s Year of the Pig.

01/07/2019

David Knutson

David Knutson

Head of Credit Research, Americas

­What happened, will happen and potential surprises

What Happened

Going into 2018, market and credit risks appeared to be relatively benign. Investors expected strong economic activity goosed by fiscal reform, a healthy consumer, sustained job growth, and regulatory relief. The backdrop helped to lift investor sentiment across the risk spectrum with expectations for modest spread tightening in investment grade and a flat to tighter trajectory in high yield. However, the year ended with macro fears and peak political uncertainty that accelerated the sell-off of risk assets. 

As luck would have it, China was a major contributor to the market swoon while coincidently providing a suitable symbol for the skinny credit returns -- the Year of the Dog.  

No place to hide


Source:  Bloomberg, Morgan Stanley Research.  Annual returns minus US headline inflation.  Green means returns (in USD) beat inflation and red means returns trailed inflation.  2018 data as of December 17, 2018. For illustration only. Past performance is no guarantee of future results.

As evidenced by the red column above, strong credit and macro fundamentals were overwhelmed by concerns surrounding the escalation of trade tensions, the Fed’s rate hike trajectory, and dramatic decline in oil prices – all of which have had spillover effects on the corporate credit markets.  Below is the Bloomberg Barclays US Aggregate Corporate index which tracks the risk premium over US Treasuries of the broad investment grade corporate credit market.  The Index spread reached an early February sub-90 tight, weakened on macro fears to just over 120 by the beginning of the summer, then tried to grind tighter over the third quarter and finally had an accelerating sell-off the last couple of months of the year finishing around 140 by late December. 

What will happen?

Fear was the controlling emotion as 2018 drew to a close.  Political uncertainty, trade conflicts, a slowing China, populism and a hawkish Fed have pushed the credit markets into risk off mode.  The difference between slowing growth and a recession has blurred as bears point to increasing uncertainty, deflationary consequences of a trade war, the relative mature expansion and the big disconnect between the market rate expectations and Fed guidance.

The 2019 consensus outlook for investment-grade (IG) and high yield (HY) credit spreads is skewed to the downside.  For IG, the market is looking for slightly higher spreads (e.g., +10 to 30bps), reflecting slower growth, limited levers for deleveraging, and potential ratings downgrades that outweigh the benefits from lower supply and attractive all-in yields.  In comparison, the market seems to be even less constructive on HY credit, with 2019 year-end spread targets ranging from 450bps to 550bps, implying widening of 25bps to 120bps from the spread levels in early December.

What do we think?  As a fundamental analyst, it is hard not to notice that the bearish outlooks and the current market sentiment contrast with generally healthy corporate fundamentals.  The market has largely focused on the lack of attractive valuation and the heightened risk of macro shocks. With valuations having already reset, we see pockets of attractive entry points, despite lower, but still favorable macro, credit fundamental and technical factors. While the proliferation of the BBB-rated universe has gotten a lot of focus, we presently see the bigger downside risk from potential downgrades of A-rated credits into BBB territory. Barring that outcome, we think the path for IG should be more constructive than what the market is currently pricing, particularly against a backdrop of solid fundamentals and lower issuances. The graph below shows that net leverage ratios have declined in HY and stabilized in IG.  Beyond the IG and HY markets, we think the following will drive performance in 2019.

Healthy balance sheets – Declining and stable leverage


Source:  Bloomberg, FactSet. Note: IG (RHS) – darker blue line.  4 quarter moving average of the median net debt to EBITDA ratios for IG and HY issuers domiciled in North America, excluding Utilities and Financials.

First, elevated bouts of volatility are here to stay, and periodic volatility spikes should present attractive risk-on and de-risking opportunities that allow investors to better navigate the “new normal” after years of central bank suppressed volatility.

Defaults to remain low

Source:  Moody’s, S&P Capital IQ LCD

Similar to IG, we see pockets of opportunity within HY for outperformance following the significant risk-off investor sentiment heading into year-end. Importantly, corporate fundamentals remain strong and default rates remain low for both HY and leveraged loans (see above chart). While we expect some credit issues to emerge, defaults should be isolated to idiosyncratic credits and companies within the energy sector. Additionally, limited new supply issue should be supportive of the valuation for the secondary market. Illiquidity and indiscriminate selling pressure should offer good opportunities to accumulate fundamentally strong companies at an attractive price.  

Second, the resolution of the ongoing China/US trade dispute has the potential to remove one of the biggest overhangs for investors and companies.  Regardless of the outcome, we see a scenario supportive of asset prices.  Continued trade disputes will pressure the Chinese economy which will likely lead to significant stimulus.  While the optimists believe the US will seek a trade victory as soon as possible, our economist, Keith Wade, believes trade tensions will persist well into next year.

Finally, while not a point of emphasis for the administration in 2018, there seems to be broad recognition of the need for greater investment in domestic infrastructure.  The announcement of a plan would provide a post tax reform jolt to an economy as it begins to face decelerating growth.

Potential surprises – The year of the Pig

Keeping with the theme of the Chinese Zodiac and hoping for better markets, we have come up with the following five upside surprises that could make 2019 the Year of the (fat returns)Pig.

1.  Zero instead of two: Heading into year-end, the markets were focused on the trajectory of future Fed policy following the Fed’s acknowledgement of a “data-dependent” approach. Now, just a short time later there is a disconnect between Fed guidance of two rate hikes and the market’s expectation.  Following the substantial declines in asset prices following the December Fed meeting, the market is ostensibly putting less weight on a “Powell put” and the Fed’s motivation to support asset prices. What will become clearer in the coming quarters is whether the decline in asset prices (across fixed income, equities, and housing) negatively impacts consumer confidence and the broader economy.  A decelerating economy would provide the data to slow the current quarterly rate hike schedule. A potential upside surprise that will be celebrated by risk takers is confirmation (or the eventual acknowledgment) of no rate hikes in 2019.

2.  Delay and re-referendum: Brexit will remain top of mind during the first quarter of 2019.  While the outcome may still take a number of different paths, we expect political stalemate over the negotiations to remain a key theme.  As the most likely outcome of a stalemate is the broadly unappealing scenario of crashing out, we think an upside surprise of an 11th-hour decision to delay and force a second referendum will push credit markets higher.

3.  Elsewhere in Europe: Going into 2019, cohesion continues to be an overwhelming risk factor for the EU.  The global financial crisis left European banks trailing their US peers as the capital rules, along with the size requirements to be globally competitive, were rewritten. We think next year could see an important consolidation of the European banking system.  A truly pan European banking champion would give the continent a formidable competitor to large US banks, reduce sovereign uncertainties, address chronically underperforming institutions and promote the ECB’s goal of improving oversight and increasing cross-border capital flows. 

4. Upside in oil: In commodities, we see scope for oil prices to outperform relative to consensus expectations, which reset lower following significant declines in December. Our view reflects a more bullish picture of the supply-demand fundamentals, highlighted by OPEC+ production cuts, better supply discipline, and continued strong demand – which together should reduce the amount of surplus oil.

HY is correlated to oil


Source:  Bloomberg

Importantly, a second order derivative of WTI rebounding to >$50 per barrel would be the psychological benefits it offers investors in the HY universe – of which the energy sector accounts for 16% of the market – and the reversal of the contagion effects that the market witnessed in late 2018.

5. Chinese stimulus: The Chinese government has thus far relied on monetary policy tools, income tax reforms, and short-term acceleration of infrastructure spending in order to carefully navigate a period of slowing growth (illustrated in the two charts below) – and counterbalanced against the PRC’s deleveraging goals. As we highlighted above, the potential for further, more significant forms of stimulus remain, particularly as the economy falters in the face of sustained trade tensions, creating what we think could be a significant offset to current trade dispute related market weakness.

 

China significantly reined in non-bank credit in 2018…


Source: PBOC, JPMorgan

 …negatively impacting the infrastructure and real estate sectors, potentially creating the impetus for significant stimulus when taking into account further impact from sustained trade tensions.

Source: NBS, JPMorgan

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.