“US high yield has been at the centre of the recent credit market meltdown, but at least here there is a compelling valuation case. While the market could remain under pressure as long as downside risks to commodity prices are in place, the widening of high yield spreads is more than we would deem necessary based on default expectations.
“The Federal Reserve (Fed), Chinese growth, liquidity and the resilience of the global business cycle will be the key themes determining returns in early 2016.
“The lack of any expectation of accelerating growth in the global economy in 2016 has been a key feature of discussion. Indeed, it seems that it is a case of more of the same with the US, Europe and emerging markets broadly expected to generate the same level of growth as in 2015. However, the downside risks are still very much in place, so sentiment in the outlook is weak. The downside risks come from weakness in global trade that is a function of the Chinese economic slowdown and the accompanied reduction in demand for industrial commodities. This has provoked a transfer of income from commodity producers to commodity consumers and, despite there being clear benefits to consumers from lower energy prices, the impact of this on macro and market sentiment has been negative.
“We were more positive in September that the oil dividend would become more evident in macro expectations, but this has not been evident. Instead there has been more corporate bad news in the broad energy and basic materials sectors and from those countries that rely on commodity exports. In the US this has resulted in higher credit spreads and reduced expectations about capital spending.
“More than ever, it seems to achieve a higher potential return, investors have to take more risk as credit markets have become bifurcated. Unless the macro backdrop improves, and that would need to include a sharp improvement in the commodity price environment or strong growth from China, the result is likely to be heightened volatility in credit markets. From an investment point of view, this means a lower quality trade-off between return and risk. The government bond part of the fixed income universe remains expensive because of Quantitative Easing (QE) and monetary policy and where things are changing in that regard – in the US for example – the risk is short term capital losses because of negative duration effects.
“In the investment grade world, despite a general widening of spreads, valuations are still not that attractive relative to either the duration risk (US) or credit deterioration. Again much depends on how the US economy looks in Q1. A bounce in manufacturing on top of the ongoing strength of employment and consumption could attract investors back into US credit markets. From a valuation point of view, the US is preferred to the euro market where QE and limited issuance will keep spreads relatively tight and overall yields low.
“A key theme in 2016 will be the duration of the US business cycle. If the current low level of the unemployment rate is signalling that the expansion is running out of legs, the recent underperformance of risky assets could extend. This would also have implications for the duration of the Fed tightening cycle, which began in December. On balance our view is that the expansion can continue, driven by growth in consumer incomes, a positive fiscal position (in an election year) and some stabilisation of external drags.
“We need to watch wage growth and corporate earnings. There has been some weakness in recent quarters on the profits side, but this is mostly related to basic materials and energy. Wage growth does not seem to have been sufficiently strong to eat into margins yet and until it does the economy can expand. Thus, there could be a bounce in risk asset performance in early 2016 and we retain our exposure to US high yield on that view.
“However, a tactical cautious approach to managing bonds is required at this juncture, with the Fed pushing rates higher and there being some default and liquidity concerns in the markets. Structured ABS and CLOs offer investors floating rate exposure at attractive spread levels while high yield loans are subject to less default risk than bonds.”
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