Warmer weather please
April 5, 2019

View from the Bond Market, by Chris Iggo, CIO Fixed Income, AXA Investment Managers

Growth fears behind us?

Global data stabilizing

But rates firmly on hold

Back to low yields

Credit rewarding

Neither cheap nor dear

Q2, warm weather and stable markets?

Blue seats

There have been some signs of global growth stabilizing, although European data is lagging. China and the US published stronger data on manufacturing last week. Bond yields have risen a bit, suggesting recession fears have receded somewhat. This is a good environment for credit in that the additional yield relative to governments is worth being exposed to. I can't really make the case that credit is cheap, nor that underlying rates might go a bit higher on better data. However, if we are in a period of better data with the possibility of some better news on issues that have been plaguing investors, credit markets should outperform.  

Growth fears behind us? – The US Institute for Supply Management's manufacturing purchasing index peaked at a heady level of 60.8 in August last year. What followed was a two-quarter period of general downgrades to the global economic outlook. Growth forecasts were reduced, odds on a recession were shortened, and future interest rate expectations were cut. The dramatic change in optimism about the global economy led to increased market volatility, a 20 percent drawdown in the S&P500 between September and December, a 228 basis point increase in the US high-yield credit spread, and a 90 basis point drop in the 10-year US Treasury yield. In other markets, where growth had never been as strong as in the US, similar market moves were seen. Much of the negative market move was seen in the first three months after the economic data peaked and the subsequent price action since the end of 2018 suggested that investors had overreacted to the data. Now, the data itself is starting to substantiate that view. Investors are sitting on strong year-to-date returns and the economic numbers are looking better again.

Global data stabilizing – The US ISM index for March was released last week at a reading of 55.3, compared to the recent low of 54.2 in February. For all the concerns about trade, tighter monetary conditions, and lower global activity, the US factory sector has continued to grow. The non-manufacturing sector has also continued to be quite buoyant and has seen improved readings since last September. There was better data from China with a widely watched purchasing manager survey showing better readings on both the manufacturing and services sides in March. Oil and other commodity prices have also continued to climb, which is not consistent with growing recessionary risks. However, in Europe the data continues to be weak, the aggregate euro area PMI for manufacturing was lower again while the services index managed a small increase. If China and the US are doing better after a half-year of softer growth it should eventually show up in stronger numbers in Europe. But the release of German factory orders for February showing an 8.4 percent decline from a year earlier, gives an indication of the depth of the hole that the core European manufacturing sector has been in recently. In the UK there has been a Brexit impact on the manufacturing purchasing managers index. The headline number increased in March, but the details of the report show this was driven to a large extent by British companies stockpiling like never before. This boosted the inventory, new orders, and output sub-indices but it was widely interpreted as showing that firms were preparing for some potential disruption to supply chains in the event of a hard Brexit. There is likely to be some payback to this in future months as inventories are eventually run down.

But rates firmly on hold – The upshot is that global data has started to justify the more optimistic price action in the markets. Interest rate expectations have not really shifted but yield curves have steepened again as a period of aggressive monetary easing by the Fed appears to be even less likely. While March was another decent month for fixed income returns the back-up in yields has meant a more difficult start to April. I still think there is decent momentum in bond markets, especially in credit, as the interest rate environment will remain benign. So far, we have just seen some stabilization of the economic data while inflation remains very low, so there is no need to start pricing in a different monetary outlook anytime soon. Indeed, with better macro data and central banks on hold, the case for credit continues to be strong. 

Back to low yields – Having said that, investors should not be under any illusion about the fact that they get less reward for holding fixed income these days. The secular decline in interest rates has meant a lower trending income return from bond portfolios. This is especially the case in government bond markets where lower yields and flatter curves have reduced the return from carry. In all markets, average coupons have been declining since the financial crisis and this is likely to continue as new lower coupon bonds are issued. So, although income has become less of a reason to hold bonds than it was in the past, it hasn't disappeared altogether. In credit markets income returns remain above rates of inflation. However, investors need to think about the total returns from bonds as much, if not more than, the income.  

Credit rewarding – Look at the behaviour of total returns from credit, they are quite cyclical. Investors get well rewarded for taking credit risk, even on a mark-to-market basis most of the time. Yet there are periods, usually around every three to four years, when credit markets significantly under-perform and experience aggressive spread widening. Since the financial crisis there have been a few of these such occasions – the European crisis of 2011, the energy crisis of 2015, and the global growth slowdown of 2018. In none of those periods was there a significant rise in defaults. The spread widening was more likely to have been driven by risk aversion (investors perceiving credit to be riskier than it is) and poor liquidity which exacerbated moves in spreads. Returns to subsequent periods of significant and rapid spread widening have been strong. The takeaway is that buy and hold investors should stay with their credit exposure through periods of volatility (as long as they are happy at the individual stock level with the credit risk) and more tactical investors should tilt their portfolios to credit when spreads widen. History suggests, at the global investment grade level, when spreads widen by more than 100 basis points (bps) over a six-month period, subsequent excess returns over the following year should be in the 10-15 percent range (that is above risk-free government bonds). Sophisticated credit fund managers can use hedging techniques to limit losses during periods of credit spread widening (buying CDS protection for example when spreads are low), thus helping to give a more positive skew to returns over time. 

Neither cheap nor dear – The sell-off in credit in Q4 and the subsequent strength of returns since has brought valuations back to a mid-late cycle level. Looking at moving averages, credit spreads are close to longer term levels so are neither particularly expensive or cheap. Thus, credit returns are likely to be driven by carry in the short-term and so active credit exposure should be tilted to the higher-yield parts of the market. At the same time, government bond yields are a little higher than a few weeks ago but the real value of exposure to government bonds is the protection they offer when we face the next mini-credit crisis. You don't get paid very much for holding government bonds, but their value is in the optionality they display when returns from riskier assets deteriorate quickly.

Q2, warm weather and stable markets? – Looking out to Q2 and Q3 of this year, the key drivers of return will be the data flow, which appears to be stabilizing, and the prospects of some resolution to the China/US trade talks and to Brexit. Both of those have probably impacted on corporate investment spending and a positive outcome, or at least some certainty, may allow some increase in capex to the benefit of industrial and technology sectors. In turn the data will help determine interest rate expectations which, if the data is more positive, should prevent any significant further flattening or inversion of yield curves. More central case is that credit and equities continue to do well in what people will reluctantly see as a benign environment.

Blue seats – It is really the business end of the football season. There are seven league games to go, the FA Cup reaches the semi-final stages this weekend and in the coming week four English clubs will be playing in the last eight of the Champions League. Remarkably, Manchester City are in the hunt for three more trophies after already securing the Carabao Cup earlier this season. That would be quite a feat tarnished only by the fact that they can't seem to fill their stadium with fans to see what might go down as one of the most successful team achievements in English football history. Of course, the challenge is immense with Liverpool vying for the league title and Spurs posing a threat in the all-English tie of the Champions League (new stadium and all that). United face Barcelona next week as underdogs to a team that is eight points clear at the top of La Liga and has only lost two league games all season. The first game is at Old Trafford which can raise itself for big European nights. The second game is in Catalonia on April 16 and you never know, great things have happened at the Camp Nou before.

Have a great weekend,

Chris

 

 





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View from the Bond Market, by Chris Iggo, CIO Fixed Income, AXA Investment Managers

Growth fears behind us?

Global data stabilizing

But rates firmly on hold

Back to low yields

Credit rewarding

Neither cheap nor dear

Q2, warm weather and stable markets?

Blue seats

There have been some signs of global growth stabilizing, although European data is lagging. China and the US published stronger data on manufacturing last week. Bond yields have risen a bit, suggesting recession fears have receded somewhat. This is a good environment for credit in that the additional yield relative to governments is worth being exposed to. I can't really make the case that credit is cheap, nor that underlying rates might go a bit higher on better data. However, if we are in a period of better data with the possibility of some better news on issues that have been plaguing investors, credit markets should outperform.  

Growth fears behind us? – The US Institute for Supply Management's manufacturing purchasing index peaked at a heady level of 60.8 in August last year. What followed was a two-quarter period of general downgrades to the global economic outlook. Growth forecasts were reduced, odds on a recession were shortened, and future interest rate expectations were cut. The dramatic change in optimism about the global economy led to increased market volatility, a 20 percent drawdown in the S&P500 between September and December, a 228 basis point increase in the US high-yield credit spread, and a 90 basis point drop in the 10-year US Treasury yield. In other markets, where growth had never been as strong as in the US, similar market moves were seen. Much of the negative market move was seen in the first three months after the economic data peaked and the subsequent price action since the end of 2018 suggested that investors had overreacted to the data. Now, the data itself is starting to substantiate that view. Investors are sitting on strong year-to-date returns and the economic numbers are looking better again.

Global data stabilizing – The US ISM index for March was released last week at a reading of 55.3, compared to the recent low of 54.2 in February. For all the concerns about trade, tighter monetary conditions, and lower global activity, the US factory sector has continued to grow. The non-manufacturing sector has also continued to be quite buoyant and has seen improved readings since last September. There was better data from China with a widely watched purchasing manager survey showing better readings on both the manufacturing and services sides in March. Oil and other commodity prices have also continued to climb, which is not consistent with growing recessionary risks. However, in Europe the data continues to be weak, the aggregate euro area PMI for manufacturing was lower again while the services index managed a small increase. If China and the US are doing better after a half-year of softer growth it should eventually show up in stronger numbers in Europe. But the release of German factory orders for February showing an 8.4 percent decline from a year earlier, gives an indication of the depth of the hole that the core European manufacturing sector has been in recently. In the UK there has been a Brexit impact on the manufacturing purchasing managers index. The headline number increased in March, but the details of the report show this was driven to a large extent by British companies stockpiling like never before. This boosted the inventory, new orders, and output sub-indices but it was widely interpreted as showing that firms were preparing for some potential disruption to supply chains in the event of a hard Brexit. There is likely to be some payback to this in future months as inventories are eventually run down.

But rates firmly on hold – The upshot is that global data has started to justify the more optimistic price action in the markets. Interest rate expectations have not really shifted but yield curves have steepened again as a period of aggressive monetary easing by the Fed appears to be even less likely. While March was another decent month for fixed income returns the back-up in yields has meant a more difficult start to April. I still think there is decent momentum in bond markets, especially in credit, as the interest rate environment will remain benign. So far, we have just seen some stabilization of the economic data while inflation remains very low, so there is no need to start pricing in a different monetary outlook anytime soon. Indeed, with better macro data and central banks on hold, the case for credit continues to be strong. 

Back to low yields – Having said that, investors should not be under any illusion about the fact that they get less reward for holding fixed income these days. The secular decline in interest rates has meant a lower trending income return from bond portfolios. This is especially the case in government bond markets where lower yields and flatter curves have reduced the return from carry. In all markets, average coupons have been declining since the financial crisis and this is likely to continue as new lower coupon bonds are issued. So, although income has become less of a reason to hold bonds than it was in the past, it hasn't disappeared altogether. In credit markets income returns remain above rates of inflation. However, investors need to think about the total returns from bonds as much, if not more than, the income.  

Credit rewarding – Look at the behaviour of total returns from credit, they are quite cyclical. Investors get well rewarded for taking credit risk, even on a mark-to-market basis most of the time. Yet there are periods, usually around every three to four years, when credit markets significantly under-perform and experience aggressive spread widening. Since the financial crisis there have been a few of these such occasions – the European crisis of 2011, the energy crisis of 2015, and the global growth slowdown of 2018. In none of those periods was there a significant rise in defaults. The spread widening was more likely to have been driven by risk aversion (investors perceiving credit to be riskier than it is) and poor liquidity which exacerbated moves in spreads. Returns to subsequent periods of significant and rapid spread widening have been strong. The takeaway is that buy and hold investors should stay with their credit exposure through periods of volatility (as long as they are happy at the individual stock level with the credit risk) and more tactical investors should tilt their portfolios to credit when spreads widen. History suggests, at the global investment grade level, when spreads widen by more than 100 basis points (bps) over a six-month period, subsequent excess returns over the following year should be in the 10-15 percent range (that is above risk-free government bonds). Sophisticated credit fund managers can use hedging techniques to limit losses during periods of credit spread widening (buying CDS protection for example when spreads are low), thus helping to give a more positive skew to returns over time. 

Neither cheap nor dear – The sell-off in credit in Q4 and the subsequent strength of returns since has brought valuations back to a mid-late cycle level. Looking at moving averages, credit spreads are close to longer term levels so are neither particularly expensive or cheap. Thus, credit returns are likely to be driven by carry in the short-term and so active credit exposure should be tilted to the higher-yield parts of the market. At the same time, government bond yields are a little higher than a few weeks ago but the real value of exposure to government bonds is the protection they offer when we face the next mini-credit crisis. You don't get paid very much for holding government bonds, but their value is in the optionality they display when returns from riskier assets deteriorate quickly.

Q2, warm weather and stable markets? – Looking out to Q2 and Q3 of this year, the key drivers of return will be the data flow, which appears to be stabilizing, and the prospects of some resolution to the China/US trade talks and to Brexit. Both of those have probably impacted on corporate investment spending and a positive outcome, or at least some certainty, may allow some increase in capex to the benefit of industrial and technology sectors. In turn the data will help determine interest rate expectations which, if the data is more positive, should prevent any significant further flattening or inversion of yield curves. More central case is that credit and equities continue to do well in what people will reluctantly see as a benign environment.

Blue seats – It is really the business end of the football season. There are seven league games to go, the FA Cup reaches the semi-final stages this weekend and in the coming week four English clubs will be playing in the last eight of the Champions League. Remarkably, Manchester City are in the hunt for three more trophies after already securing the Carabao Cup earlier this season. That would be quite a feat tarnished only by the fact that they can't seem to fill their stadium with fans to see what might go down as one of the most successful team achievements in English football history. Of course, the challenge is immense with Liverpool vying for the league title and Spurs posing a threat in the all-English tie of the Champions League (new stadium and all that). United face Barcelona next week as underdogs to a team that is eight points clear at the top of La Liga and has only lost two league games all season. The first game is at Old Trafford which can raise itself for big European nights. The second game is in Catalonia on April 16 and you never know, great things have happened at the Camp Nou before.

Have a great weekend,

Chris

 

 



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