Our base case expectation is for commodities prices to remain lower for longer as global oversupply continues to weigh on markets. The continued surplus in oil has allowed inventories to build to record highs, and the risk of storage congestion has increased materially for 2016. In industrial metals, the supply/demand imbalance is more directly related to slowing growth in China, which accounts for 40%-50% of global demand for base metals. We do not expect supply in base metals to correct quickly, since market prices for industrial metals are still above cost of production in many cases.
We are estimating a total return of 2.5%-3.5% for US high yield in 2016 (Exhibit 2), an estimate which assumes a doubling of the default rate, driven disproportionately by commodity-related sectors2.
We see upside risk to our target total return if key commodity prices can stabilize and recover modestly by mid-2016, allowing the energy and metals and mining sectors to react in a similar fashion.
We see downside risk in a scenario of continued commodity declines, rising volatility driven by monetary policy, prospects for elevated net new supply in the form of possible “fallen angels” (bonds which were once rated investment grade but are now part of the high yield market), and the seasoning of the credit cycle as the market absorbs the reality of an accelerating default rate.
We are seeing increased signals that the high-yield sector is progressing into the late stage of the credit cycle. Corporate fundamentals have been slowly deteriorating, with higher merger and acquisition levels contributing to increasing leverage. We expect that margins may begin to retreat from their cycle peaks and revenue growth will slow; several sectors are already seeing revenue and earnings declines year-over-year. Refinancing has slowed. Though the market’s maturity profile is quite benign, the cost of debt is rising for high yield issuers, which will gradually stress their ability to service their debt. These factors underpin our view that the default rate, which has remained below average for six years, is likely to accelerate to 5.5-6% in 2016.
Acknowledging the deterioration in fundamentals that is occurring, we nevertheless see value in some areas of the market. Valuations have been driven to what we consider to be extreme levels. We believe select credits can offer attractive compensation even relative to the increased risk in today’s market. While it is not our central case that the US is experiencing or will experience a recession in 2016, we do note challenges have increased within the high yield market. We believe present conditions merit a cautious approach, wherein tactical positioning and security selection will be key.
