We do not share some of the fixed income market’s concern over near-term recession risks, but we do recognise that we are in a very different environment than we were a year ago.
Financial conditions have tightened, US fiscal policy stimulus should begin to fade, and political risks are likely to remain elevated in both the US and Europe.
China is providing fiscal and monetary support to its economy, but we suspect that investors will remain unimpressed with the targeted nature of the effort – absent a material deterioration in the outlook, perhaps on any worsening of the trade dispute with the US, a return to full-bore Chinese stimulus is highly unlikely.
All of these factors can weigh on household and business confidence, posing risks to aggregate demand.
In addition, corporate profit growth is decelerating in many major economies (see Exhibit 1 below). Of particular note, in the US, some of the decelerating profit growth is due to margin compression. This is not a surprising development given that fiscal stimulus pushed the economy far above its potential rate of growth, leading to higher labour and input costs across a number of sectors.
If this margin compression becomes more acute, hiring and investment spending could weaken, causing growth to slow below its trend rate, which we estimate as 1.75% to 2 %. Even if this more significant scenario does not play out, an environment of declining margins could pose challenges not only to US equities, but also investment grade and high yield credit.
Exhibit 1: Decelerating corporate profit growth - year-ahead earnings-per-share estimates for selected regional equity markets
Source: FactSet, BNP Paribas Asset Management as of 10 January 2019
Appealing alternatives in the fixed income space
From a relative value perspective, asset allocation alternatives that once were economically unappealing due to financial repression are beginning to look more interesting again.
Given significant flattening of developed market government bond yield curves, traditional havens such as certificates of deposit (CDs) are now yielding 2.25% for little to no risk; and the yield on commercial paper (CP) now averages 2.7%. For those willing to extend just slightly further out on the fixed income maturity curve, even two-year investment-grade credit with an average risk premium of 100bp brings the all-in yield to 3.5%.
These alternatives have a clear impact on risk taking in a world where economic growth is expected to weaken and violent bouts of volatility are common. To us, this suggests that there is little benefit to taking a long spread duration position and that the best exposures in fixed income are in the front end of the risk space.
Tactically, we are positioned for a near-term rally. We express this mostly in the US high-yield (HY) market. We expect fourth-quarter company earnings to exhibit modest growth (albeit lower than that of the second and third quarters). Supply technicals should help as well given the limited issuance.
US high-yield spreads have widened from 300bp in early October to 525bp at the start of 2019. At that level, the market is pricing in the possibility of recession in 2019, which we think is overdone.
Longer-term, we are more inclined to be underweight credit globally and believe that security selection will play a larger role in fixed income performance this year.
In particular, leverage has increased significantly, and many over-leveraged companies will likely exhibit stress. Anecdotally, we have already seen market liquidity tighten in the CCC rating bucket as those companies that took full advantage of leveraged loan liquidity will seek to term out their growing debt burden.
Key to this will be the health of the CLO market. If we see liquidity dry up there, we believe HY spreads could widen by at least 100bp. More specifically, in the oil and commodity sectors (a substantial driver of high yield performance), we acknowledge the volatility that has occurred as oil prices dropped materially over the fourth quarter.
We are still constructive on some energy companies that have low production costs and modest leverage. Many energy companies are in a better fundamental position compared to the 2014-2015 drop in oil prices. However, near-term performance will likely be driven by supply/demand dynamics – the OPEC+ agreement and the global demand outlook.
Emerging market debt
Although 2018 ended on a positive note for all sub-segments of emerging market fixed income, we enter 2019 cautiously and with an expectation of another challenging year ahead given expectations for an uncertain global growth backdrop.
These tough conditions are likely to be felt more keenly in hard currency assets, as credit spreads historically trend up with elevated volatility. Although there may be some short-term relief in spreads on technicals, we expect spreads to remain elevated, with sovereigns underperforming corporates, and a higher incidence of defaults that will generate bouts of contagion.
However, we see pockets of value in high-quality high yield credit, especially since emerging market corporates demonstrate better liquidity metrics, lower leverage and more responsible borrowing than their developed market counterparts. Controlling for quality, the EM credit asset class remains cheap relative to US high yield.
We continue to be more constructive on local currency assets, where we remain overweight in our asset allocation model. Supporting this position is our belief that underlying growth concerns are overdone and that emerging market growth will not slow as much as consensus expectations suggest, especially in China.
Additionally, we think that US dollar strength may be a fading 2018 story as the Federal Reserve pauses and adopts a more data-driven approach. However, uncertainty remains as to how this will eventually play out during the course of the year for each of the countries in question.
Individual country stories will both drive and limit the upside growth view. As an example, we believe that Turkey will enter a recession in 2019, but the key driver will not be if, but how severe this recession will be. Conversely, although South Africa is enjoying a recovery from the recession it experienced in the first half of 2018, it remains unclear how strong the rebound will be.
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