Credit markets have rebounded sharply in recent weeks. How has this changed your view of risk/reward in the market?
Ben Johnson: We are mindful of increased two-way risks at this late stage of the cycle and our stance has become progressively more cautious. That said, absent another shock, it’s possible that the credit cycle could extend a couple more years, and we are still modestly constructive on the investment grade market as we believe spreads can tighten further on fundamental factors.
Our concerns about the cycle are reflected in our selective positioning. We see value in consumer products, banking and tobacco, mainly as a result of single-security, bottom-up views rather than thematic sector-level decisions. We are still neutral on the energy sector.
Michael Goldstein: We have scaled back to a neutral position in high yield as the market has just staged one of the sharpest rallies on record, bringing valuations close to fair, in our view. Spreads have tightened 250 basis points from February’s wides, and some of the lowest quality and most out-of-favor industry groups have witnessed outsized gains. We now see less room to absorb negative developments, such as renewed concerns about global growth, or a reversal of recent commodity price gains.
There’s a lot of focus on mounting risks in credit, and this has been an extended cycle—what could end it?
Goldstein: Cycles don’t tend to die of old age—they’re usually finished off by an external shock or change in policy. This cycle has already run for seven years, but most indicators of recession are still quite benign and policy is very accommodative.
That said, investors may be underestimating the potential for volatility as we think US markets will have to adjust to a somewhat steeper path of rate hikes. The Federal Reserve has scaled back its policy projections—at the start of the year Fed policymakers envisaged four hikes, and now it looks more like two—but we still think futures markets are underpricing the likely action. And the Fed could move faster if inflation surprises to the upside.
Risk factors in China are still tough to gauge. Credit growth remains strong and is getting harder to translate to economic growth, and bad lending could result in investment losses. Among the most worrisome developments are accelerating outflows and unorthodox policy responses, and we’re also concerned about more volatility if growth undershoots forecasts or commodity prices take another leg down. Such scenarios could have large and unexpected impact across markets, and it’s difficult to predict a possible timeframe.
What are the positive catalysts that help make the case for continued exposure?
Johnson: The key positive driver for credit is yield —roughly $8tn of fixed income securities globally are now yielding in negative territory.1 We think the search for yield among overseas investors—particularly in the European and Japanese markets—could sustain a solid bid for credit. We don’t see this yield-constrained environment changing anytime soon.
As for the specifics of the European Central Bank’s (ECB) monetary policy, we don’t want to overstate the market implications of the new corporate bond buying program. The experience of previous purchase programs, such those involving asset-backed securities and covered bonds, showed the largest impact on spreads before purchases actually began, as spreads moved tighter in anticipation. The ECB starts buying corporate bonds in June but we believe the European investment grade market has probably already felt most of the beneficial impact.
Goldstein: By contrast, we expect a continued positive portfolio effect on high yield names from the ECB’s corporate bond purchase program, as this new component of the QE program drives demand further out the risk spectrum. So far, double-B credits have outperformed the rest of the market in Europe.
Broadly speaking, we think continued monetary stimulus is supportive in the near term but could also add leverage to the system or stoke market volatility. This concern, combined with the late cycle developments in the US, underpins our preference for larger and more-liquid positions that allow us to be more tactical in adjusting risk. We also favor higher quality, and in high yield we are focusing more of our security selection at the upper end of the credit rating spectrum, including fallen angels.
You mention a couple of challenges investors may be underestimating. Do you see potential for positive surprises?
Johnson: Despite the challenges of a sluggish economy and weak revenues, US companies may have better times ahead. Margins are peaking—they haven’t fallen at an alarming rate but we have seen some decline. But if consensus forecasts are right, this deterioration may be short-lived. Estimates for US earnings per share (EPS) growth in the second half are positive, though sharper dollar appreciation could weigh on this outlook.
The other potential surprise is more technical. We think supply could be lower than anticipated, if not turn negative this year, in part because of declining M&A activity. M&A faces a variety of setbacks – including the recent bouts of volatility, broadly bipartisan political resistance to corporate inversions in the US election year, and increasing instances of regulatory checks on consolidation in some industries. We think reduced incremental supply is an added boost for markets offering yield at a time when yield is getting scarce.
We’re also watching the June 23 UK referendum as a potential market mover. We’ve seen some softening in European markets exposed to a potential vote to leave the European Union, so we believe a resolution to stay could drive rallies.
