Whereabouts are we in the credit cycle?
Simply looking at measures of the credit cycle, for example, ratings upgrade-downgrade ratios or default rates, the environment still appears fairly benign. In the US, the rate is improving and not showing the signs of deterioration that are often seen ahead of a recession. In Europe, the balance is quite positive.
For high-yield credit in the US, excluding commodities, the rate of issuer defaults has been declining from the surge that began in 2016. In Europe, the ratio remains low.
Worrying lack of discipline
We are nonetheless in the later stage of the US economic cycle and it should be just a matter of time before worries about growth drive investors to favour government bonds over corporate debt. We are worried about a lack of discipline among corporate debt issuers.
The stimulus from the tax cuts should eventually fade, while the US Federal Reserve will still be raising rates to forestall an increase in inflation and will still be reducing the size of its balance sheet. It is then that the build-up in corporate leverage over the last few years will likely become a problem for company treasurers. The asset class has seen significantly lower fund inflows compared to 2017 as investors began to anticipate rising interest rates.
The tortoise and the hare
In contrast, the eurozone economy may not have shown the same vigour as that of the US, but as far as credit is concerned, it has the virtue of the tortoise versus the hare. The Bloomberg Barclays eurozone credit index outperformed the euro government bond index as at 31 October 2018. By contrast, in the US, only high-yield (slightly) bettered government bonds.
Europe, however, faces the prospect of a much steeper normalisation of monetary policy in 2019 as quantitative easing ends (including the ECB’s Corporate Sector Purchase Programme (CSPP)) and the ECB may begin to raise interest rates. While this normalisation has already progressed reasonably far in the US (Treasury yields are well above the levels seen in the QE-era from 2010), yields of Bunds are still quite depressed.
Exhibit 1: Variations in the yields of selected benchmark 10-year government bonds, 2010-2018 (in %)
Source: FactSet, BNP Paribas Asset Management, as at 31/10/2018
Have we seen the high for global equities in this cycle?
We do not see a near-term trigger for a sustained, negative trend in global equities, though the “leader board” will likely be different in 2019. The most likely catalyst for a broad downturn would be a US recession. With consensus forecasts for GDP growth of 2.5% in 2019 and 2.0% in 2020, recession is clearly not what economists expect. A recession will occur, but with US tax cuts and fiscal stimulus still stoking economic growth in 2019, and US inflation contained (allowing for only modest additional rate rises from the Fed), a recession is still a reasonably distant prospect.
In developed economies outside of the US, a recession seems even less likely. The recovery of the eurozone has been gradual compared to that of the US. Inflation remains well below the ECB’s target and there is still spare capacity in the economy.
US tech: the outlier
The clear outlier for valuations is the US, but this more notably concerns the technology sector (including internet retail). Price-to-forward-earnings multiples are only 0.2 standard deviations above the long-run average, but 0.9x and 1.2x above on price-to-book and price-to-sales. The PEG (price-earnings-to-growth) multiple, however, shows that there may still be opportunities in the sector (and hence the US market).
The PEG is below zero, that is, below the long-run average, suggesting that the price investors are paying for the index is not excessive relative to the earnings growth outlook. Unfortunately, these growth estimates come from equity analysts and hence are likely to be unduly optimistic, but we still believe the medium to long-term outlook for the sector is very promising.
Importantly, earnings revisions are still good across the major markets. US tech not surprisingly has the best profile, followed by emerging markets (see exhibit 2). The projections for the rest of the US market are more modest, and in line with those for Europe ex-UK, but still show the potential for further equity market appreciation.
Exhibit 2: Forward earnings estimates, Oct 2017-Oct 2018 (Oct 2017 = 100)
Note: Indices in local currency, EBITDA for US indices. Source: Bloomberg, BNP Paribas Asset Management, as at 31/10/2018
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