Spreads Wider, Sentiment Poor – do we buy?

The data still tells us that the US economy is strong and that Europe is on a firming trend. Yet sentiment has collapsed. We hear talk of global recession and rising defaults. The bond market is seeing wider bid-offer spreads and poor liquidity.

It is true there has been a demand and terms of trade shock in emerging markets and many of them are beset by financial imbalances, but are the developed economies necessarily de-railed by this? Clearly the jury is out and so is the Fed. We are watching the credit stories to see if there is a more sinister them, but so far it has been very EM and commodity related. Yellen still wants to raise rates before year-end – she must be relying on a couple more 200,000+ payroll prints and a strong retail showing over Thanksgiving weekend. For the short term we take the view that a global recession is not the central case and look to get returns in parts of the bond market where sentiment is weak, spreads have widened but fundamentals are not that bad.

Blame it on China – Sentiment in financial markets has turned sour since the middle of August, triggered by the decision of the Chinese authorities to liberalise the mechanism for setting its foreign exchange peg. As that resulted in a temporary fall in the value of the currency the response in markets was that China was devaluing because its economy was collapsing and, as it is the second largest economy in the world, this would herald a global recession. China has been slowing down for a while. It last printed a double digit GDP growth number in the first quarter of 2011 and for the last year the official growth numbers have been slowly edging down towards 7.0%. Our economist forecasts a sub-7% growth rate next year, but the delta of the growth number from 2014 (7.2%) to that is less dramatic than some of the changes in forecasts and market commentary. The reason for the sudden change in sentiment during the summer comes not from the Chinese numbers themselves (there are plenty of economists that think growth is actually stabilising with house sales rising and consumer spending doing pretty well) but from the derivative implications elsewhere. Commodity prices did take another leg down in August and it does appear that the weakness in emerging markets as a whole is now starting to show up in corporate news in the developed world. A number of negative credit stories in the European high yield market in recent weeks have a common link – Brazil, while global purchasing manager manufacturing surveys are underperforming their service sector equivalents.

Weak sentiment means credit concerns – Certainly from a fixed income perspective the worsening of sentiment is manifest in greater concerns about credit. A contrarian might argue that these concerns are overdone in the developed markets and we should be more worried about interest rate risk, at least in the US and the UK where unemployment rates are getting close to the lower bound. But the credit concerns are understandable. It is all too easy to dismiss individual credit stories as being one-offs. The Volkswagen story as a case in point – on one level this is not about the underlying business, its product or sales opportunities but about poor governance and bad judgement. However, there are clear implications for that companies finances (fines), its investment costs if it has to provide adjustments to millions of vehicles, its reputation and future cash-flows. Investors will also read across to other car companies that have diesel fuelled models and to the component sector that supports them. What seems at first to be an idiosyncratic event can escalate to a wider credit problem. More broadly, those companies that do business in emerging markets will be concerned about sales and revenues while creditors will be watching to see if this leads to a broad deterioration in credit metrics. So far most issues are related to those companies that have direct business exposure to emerging markets or are in the energy and commodity sectors – that’s not to say this is not important but not quite yet an economy wide deteriorating in credit conditions.

Wider spreads means better value – Sentiment is driven by expectations that are typically linear projections of today’s news. The news flow at the moment on the corporate sector is not great, thus confidence has fallen sharply. This manifests itself in big price moves in the corporate bond market at the merest sniff of bad news and, given the structural backdrop of poor liquidity, trading bonds becomes more difficult. Bid-offer spreads have widened, the new issue market – which had a bit of a kick-start in early September – has slowed again and overall spreads are wider. The US investment grade market trades at an average spread of 170 basis points over Treasuries while the equivalent spread for European investment grade has jumped to 136bp from a low this year of 89bp. The US is already at the same spread level as during the “taper tantrum” of 2013 and the European market is heading there. In sterling the credit market has not sold off quite as much reflecting the very low level of issuance in sterling and its yield advantage over European investment grade. In our recent strategic investment updates we concluded with a relatively benign view of investment grade markets but with limited conviction about a strong reversal of recent spread widening. It could get worse before it gets better but it is important to note that the credit market offers the best value it has done for a number of years.

Many bridges to cross for Emerging Markets – The emerging market story is not just about China. Having any view on the prospects for a recovery in emerging markets requires an understanding of what the current malaise stems from. There is clearly a world trade and a terms of trade impact from slower Chinese growth. But there are domestic imbalances that complicate how policy makers respond to weaker external conditions. Since the financial crisis and the introduction of unconventional monetary policies in the developed world, leverage has risen sharply in emerging markets. Official data suggests that private non-financial credit has risen from around 80% of GDP to close to 130% of GDP in emerging markets. A lot of that is in China itself related to speculative real estate and financial market activity, but other Asian and Latin American countries have seen rising private debt levels. Credit to the private sector continues to grow at around 10% per year which is faster than nominal GDP growth. This growth in private debt is a function of low global interest rates and strong capital inflows to emerging markets during the US QE period. Global monetary conditions are not tightening but they are not easing at the same pace with the Fed potentially close to raising rates. In essence, the credit bubble in EM is starting to deflate. We know what that means – reduced investment, need to de-leverage, disinflation and lower growth. It also means that banking systems come under pressure as non-conforming assets become more of an issue. We also know that the response has to be aggressive in terms of monetary policy – so we should expect interest rates to keep falling where they can in emerging markets. The problem for some is that money is flowing out, pushing down currencies and raising inflation. Brazil’s real has lost 25% of its value against the US dollar since the end of June, its inflation rate is running at 9-10% and its overnight interest rate is 14.25%. If a country also has dollar debt and not much in the way of dollar export earnings, that is an additional squeeze.

Fiscal policy to the rescue? – The good news, if there is any, is that across emerging markets the public finances are not quite as bad as in most of the G10 economies. On average, public debt stands between 40%-50% of GDP. This provides some policy flexibility to boost growth through tax cuts or spending, or to provide capital to stressed banking systems if necessary. The one major hope for China is that the authorities do have that flexibility to provide a fiscal boost to the economy financed through the state owned parts of the financial sector. Stabilising Chinese growth would help the rest of the world come to terms with the new growth regime. But monetary policy is also likely to be part of the solution to the debt-deflation problem. Central banks have fought hard to earn credibility in recent decades but imagine if QE became a popular policy choice in the emerging world too, and what if the Fed responds to weaker global growth with QE4. There’ll be no bonds left for the rest of us (if there are, I hope they are inflation linked).

Eek out some short duration credit premium – It is hard to have strong views in these markets when there is such uncertainty. If global growth has struggled to be 2.5% since the crisis it does not take much of a slowdown to push it close to recession just as inflation in a zero-2% range underscores concerns about persistent deflation. Unless policy can decisively deliver inflation or boost growth in ways that don’t just involve printing more money, sentiment is going to remain very fragile. That argues for low returns and higher volatility. To boost returns we need to seek the opportunities provided by attractive valuations and poor sentiment combined with a relatively constructive fundamental view. At the moment, to us that means US and European high yield in either the bond or loan space. It doesn’t mean emerging market debt yet for many of the reasons mentioned above even though valuation and sentiment are getting to extremes. For investment grade it remains the core of our fixed income strategies – it will deliver positive excess returns relative to government bonds (especially in short duration strategies) and will avoid some of the more worrying credit stories (assuming that VW is a one-off).

Sun, sea, cycles and Sangria – I went cycling in Mallorca last weekend and achieved a personal first by riding up a challenging mountain pass that overlooks the town where I stay. Hardly Chris Broome standards but for me a pleasing accomplishment. And the view from the top was spectacular on a beautiful Mediterranean September afternoon. It was the top of my world that weekend. Well Manchester are one and two at the top of the Premier League at the moment and United have found the new Thierry Henry. Seriously, the goals that Anthony Martial has scored so far have been taken with such poise that there is a definite resemblance to the Arsenal legend. Despite Chelsea’s poor start to the season (on and off the field) they will still be top four along with Arsenal. Along with City and United, Chelsea are away to a team that was humiliated in the Capital Cup this week. What chance a bounce-back for both Tottenham and Newcastle on Saturday? Louis van Gaal top of the Premier League by the time the X-Factor starts. That would make my weekend back in grey and miserable Wandsworth.

Chris Iggo – CIO, Global Fixed Income – AXA Investment Managers (AXA IM)