20th May 2016 by Chris Iggo
It is an indisputable general point that risky assets perform well in economic expansions and safe assets perform well in downturns. The problem at the moment is that we don’t know where we are going next. Indicators suggest that we could see economic expansion or contraction. At the same time valuations are not particularly attractive. A US rate hike is again on the cards and investors need to keep asking the question of what happens to risky assets in a rising interest rate environment. Does the world need higher rates? Probably not given the balance sheet constraints. Is the world ready for higher rates? Probably not given the balance sheet constraints. But the Federal Reserve (Fed) needs to get rates higher so it has some room to cut them when the cycle does turn down. How far and how quickly rates rise is really down to growth and inflation. As always, watch the data.
Old School – The US Institute for Supply Management’s (ISM) monthly purchasing manager survey still provides some of the best information on the cyclical position of the US manufacturing sector. By extension it tells us something about where the broader US economy is, about the world picture and about what is the likely state of financial market sentiment. Over a long period of time the ISM index has captured the cyclicality of the US economy through its measurement of new orders, production, employment and pricing. It is an important signal for asset allocation across asset classes and within. Very simply, a period of rising values for the ISM index represents rising economic growth which is supportive for corporate income and consumer spending, while a period of falling values represents slowing or negative growth, tending to mean lower inflation and interest rates. For our approach to managing fixed income portfolios across the broad asset class it is very useful in determining the tilt towards government bonds in periods of falling ISM values or towards high yield in periods of rising ISM values and economic expansion. The difficulty is identifying turning points to change the risk exposure, but that is why we employ economists and spend many hours of the day pouring over economic data and central bank communications.
Boom, boom, bang – At the time of the financial crisis, the ISM fell to a reading of 33.1. This was preceded by a long period of steady economic expansion following the recovery from the dot-com boom at the beginning of the millennium. The ISM peaked at 61.4 in May 2004 and remained above the “break-even” level of 50 until November 2007. That was a period where the rising tide of economic growth lifted all financial assets. Generally risky assets performed well (US high yield index beat the US Treasury index by 9.4% over the period). However, things quickly deteriorated at the end of 2007 and by December 2008 the ISM was signaling a deep recession. As growth collapsed during 2008, risky assets had a shocking time and US high yield underperformed Treasuries by 48%. Emergency monetary policy delivered a recovery in 2009-2011 allowing the ISM to climb back to 59.9 by February 2011, a period during which high yield had a stunning recovery while returns from rates markets were flat. Since then the cycles have become more muted. The ISM has been in a range of 48.8 to 58.1 since November 2012. Consequently, the differences in total return across asset classes have been reduced. High yield has beaten investment grade and government bonds, but the differences are far less than in more volatile macro periods. Indeed, the key driver of returns has not been the cycle but the fight against deflation, the grind lower in global interest rates and the extension of quantitative easing. These policy moves have been to the benefit of all fixed income asset classes.
All the wrong reasons – Where are we today? The April ISM index stood at 50.8 – a level that suggests the US manufacturing sector is standing still. The markets seem to interpret that as being a metaphor for the entire US economy – growth is stagnant so corporate earnings are lackluster and risky assets can’t perform. Yet at the same time the Fed has provided a firmer signal that it is ready to increase interest rates in June. If the Fed is confident that the economy can strengthen from here and the long period of subdued manufacturing activity that resulted from the China slowdown is coming to an end, then we should see higher ISM prints in the months ahead. More confidence in the economy should allow shorter-duration, higher credit risk assets to perform even with rates going up. However, the proof needs to be in the data and we haven’t seen it yet. So this week as the Fed hinted at a June rate hike, rates and credit markets both started to sell off. At this stage it is not clear which scenario is the more likely – the ISM enters a period of decline, signaling recession as we enter 2017; or it steadily moves up to the mid-50s as the ongoing stimulus from low energy prices and low interest rates, together with a more relaxed fiscal environment, moves GDP growth back to trend? I feel it should be the latter but the lack of corporate investment and the cautiousness of the household sector remain drags. In the GDP data, US fixed investment was down in Q1 and only 1.9% higher in real terms compared to a year earlier. There has been no investment boom.
Full moon rising – A valid question for credit investors is why is US corporate debt rising so quickly if fixed investment spending has been so lacklustre. To date, according to market estimates, there has been close to $600bn of investment grade corporate bond issuance. The Fed’s own flow of funds data (to end-December 2015) shows that the non-financial corporate sector debt stood at 70% of GDP. In 2008 it reached a peak of 74% before falling back to 65% but has been rising steadily since. Much of that has come through bond issuance and the combined face value of the Bank of America Merrill Lynch indices for US corporate investment grade and high yield debt now stands at 37% of GDP compared to less than 20% at the onset of the crisis. The corporate sector has also moved into financial deficit. This normally happens when firms spending on investment exceeds retained earnings with the gap being financed by borrowing. The financial balance turned negative in early 2015 and looks to be on a southerly trend. Again, the situation is not as bad as it was in 2008 or during the dot-com recession, but the trend needs to be watched. This is especially true if the increase in indebtedness is the result of financial leverage rather than capacity expansion, which appears to be the case. This week, Dell, the US computer company, sold $20bn of bonds to finance the acquisition of EMC Corporation. This is not the first big deal to be financed by debt in the current cycle. It is not likely to be the last either given that borrowing costs remain relatively low and that investors need assets with yield. A nasty scenario for the US credit market in the months ahead is that more rate hikes start to be discussed by the Fed and companies rush to issue debt before borrowing costs rise. The easy financing environment has driven leverage yet we have had the leverage before we’ve had the economic boom. Normally a shift into corporate sector deficit pre-dates a downturn in the ISM and slower economic growth. Higher levels of financial leverage might mean that when companies do want to finance real investment, the market just won’t be there to lend the money at the right price anymore. On many levels it is difficult to think that we will not get a sharp increase in market rates and bond yields at some point in the future. A very indebted corporate sector combined with higher rates and slower growth. Ouch!
Arriba – In the short term the challenge is to shape bond portfolios according to relative value. Investing in high yield is not as attractive now as it was three months ago when yields were 2.5% higher in the US and 1.5% higher in Europe. We are not of the view that spreads blow out anytime soon but when you consider that -excluding the energy sector- the yield on US sub-investment grade is down to 6.4%, there is an argument to lighten up on positions – and from a stance in Q1 where we were very heavily weighted towards that part of the market. As mentioned before, having some US Treasury long duration exposure as a partial hedge against the spread risk is also sensible. But for core fixed income it is rather a snooze-fest at the moment. Europe has a long list of things to be concerned about – “Brexit”, no government in Spain, still low growth – but markets aren’t offering much for investors to get their teeth into. Peripheral government bond spreads have widened – remember they are measured relative to German Bund yields – but the all-in yield is still just 1.6% on 10-year Spanish debt and 1.5% in Italy. Emerging markets are plodding along. The have weakened a little because of the modest re-pricing of US interest rate expectations, but yields remain well below 6% (the hard currency sovereign spread reached 6.8% in February). The slow shift back towards political credibility in Brazil is generally helping sentiment and markets were fairly accepting of a $6.75bn bond issue from the Brazilian state owned oil company, Petrobras. The timing was not great given the re-assessment of US interest rates, but generally borrowing costs for Brazil have fallen dramatically in recent months as it became increasingly obvious that Rousseff’s grip on power was slipping. Higher oil prices have clearly helped as well and my emerging market colleagues were telling me the other day that Latin America has been the key driver of emerging market bond returns so far this year. That is good news for global re-balancing if China is permanently going to be growing more slowly.
Risk is a many wonderful thing – The challenge for managing bond portfolios is always to achieve the correct balance between duration risk and credit risk through the economic cycle. Some bonds that are very safe or defensive from a credit point of view can still be very volatile depending on their duration, while others that are lower rated in credit terms can still be defensive if they are short-duration and provide a good premium income. When rates and credit spreads are at or near their lows, as has been the case in recent years, the tendency will be to move towards the lower duration, better quality end of the credit spectrum. If it is rate hikes that cause concern, then lower duration is obvious, if it’s a downturn in growth, then longer duration hedges the credit risk in a mixed portfolio. We are sort of in a phoney war now. Valuations are getting richer, the rate hike risk is very specific, and global growth is close to stall speed. Expectations about returns should be very much kept in check. Let’s see where that ISM goes in the next few months