This Time Next Year Rodney 2018
6 December 2017 by Mark Holman
After what has been a terrific year for risk in 2017, making our predictions for the upcoming year is all the more challenging. The risks we won’t be taking seem to be much easier to list than those that we will, so we’ll start with those. But before we embark on 2018, we should review our predictions for 2017.
The Trump extended economic cycle gave us confidence to own credit throughout the year and with the global coordinated economic recovery in full flow, all dips were shallow and short lived as investors gained confidence. As a consequence, volatility remained low all year and asset prices firmed across the board. Additionally the big four central banks added around $2 trillion to their balance sheets as the period of ultra-easy monetary policy glided throughout the year.
Yes, markets were expensive, but these are pretty much the perfect conditions for expensive markets, and investors should remember that markets are expensive for longer periods than they are cheap, so patience proved to be the winning principle for investors who stayed with their long positions in 2017.
Our US rates view at the front end was for an active Fed which would implement two to three hikes in 2017; in fact it looks like they may even put through four. In Europe, our Q.E. taper call was correct as Draghi reduced purchases down to €30bn a month while maintaining the Refinancing Rate at minus 40bps. In the UK our base case was for an unchanged position by the MPC, and Carney’s late 25bps hike somewhat surprised us. Further along the yield curve our call was for 10 year Treasury yields to grind higher as signs of inflation finally crept through, but ultimately it was just the expectation of inflation that moved the 10 year out to 2.62% in March, after which the reality of four successive undershoots to the monthly inflation data allowed Treasuries to recover to 2.40% as we write, leaving them more or less unchanged on the year. The main feature to note was the flattening of the $ yield curve that happened during the year, which is consistent with this stage in the cycle, where the central bank is tightening. So while rates markets were not as bad as we had expected, credit markets were even better than we had forecast with considerable spread tightening across the board. Our top two sector picks for the year did particularly well, namely the Additional Tier 1 (CoCo bond) sector and the Collateralised Loan Obligation (CLO) sector within ABS, both of which had double digit returns. The insurance sector and EM should also be mentioned as areas of material outperformance. A portfolio comprised of just these four would have been ideal!
Moving on to our outlook for 2018, which as we mentioned is more about what we don’t want to own than what we do.
We certainly do not want too much exposure to the longer end of the € rates market; 10 year Bunds at 0.33% make very little sense and are the closest thing to the word ‘bubble’ that we can think of. Yields have been driven to these ultra-low levels by an aggressive ECB purchase programme, which at times was buying up to 7x the net supply of Eurozone government bonds. We think this programme will end in September 2018, leaving the market vulnerable. A move to 0.75% would be small but would cost investors 4% in mark-to-market terms. It would be easy to see an even bigger move. While on the theme of the ECB, very simply we don’t want to be buying the same assets that it has been buying, because the technical position in these is highly distorted. For example, the IG € index is just 42bps over asset swaps for an average rating of A3 and a 6 year maturity, and is priced quite literally to perfection. Another area to treat with caution.
In the UK it is hard to find a likely scenario that we believe will not harm gilt prices. A messy Brexit could result in a Corbyn-led Labour government, which from a markets’ perspective frightens us more than anything we can think of. The market could quite possibly lose confidence in the UK’s ability to finance itself, thereby pushing gilt yields materially higher. Alternatively, and more likely, is that we do have a Brexit solution and economic uncertainty is somewhat removed, thereby enabling the UK to catch up with the global recovery; in this scenario it points towards higher rates and higher yields. Forecasting gilt yields into 2018 is not a high quality prediction, but needless to say, we see them going higher and by enough to want to avoid them completely at this stage. Similarly, for Europe, we don’t want to be buying high quality low spread £ credit that is priced off the longer end of the gilt curve.
Lastly on rates we still don’t think we should buy longer dated US Treasuries just yet for any reason apart from tactical considerations. Having said that though we think the 10 year Treasuries will only go to 2.75%, while the Fed funds increase another three times in 2018, meaning we see further flattening from here. A starting point for 10 year Treasuries of 2.40% still just about gives us a negative return over a calendar year, so we would rather wait for a spike in yields before taking on much $ duration risk.
Now on to credit, where we are generally a lot more comfortable, but we must still acknowledge the stage we’re at in the cycle, and with valuations as well as sensitivity to rates products that we don’t like. Beginning with the latter, we have already touched on € investment grade, but $ offers just 105bps over the swap rate for 10 years of risk, whereas in £ where we have real concerns, the spread is reasonable at 132bps (for 12 years); however, our rates view would steer us away from bonds of any material duration, despite the Brexit premium here. Although we do not see the cycle ending in 2018, we believe we should already be avoiding certain sectors that would fare worst at the cycle’s end. This means, for example, avoiding CCC rated bonds, which barely compensate investors for the default risk, and also avoiding unsecured or junior bonds in the cyclical corporate sectors. We should also be mindful that tight spreads open markets to borrowers who otherwise could not borrow in the capital markets. Avoiding 2019’s skeletons will be an important job as we position for 2018. High yield retail and technology are two specific sectors that we should treat with considerable caution.
So that’s a large part of the fixed income universe carved out! Where can we invest and still achieve the desired outcome of income and capital preservation?
The good news is that fundamentals are intact and we should once again see an expansion in global growth in 2018. The absence of any material signs of inflation will allow central banks in aggregate to continue with their ultra easy monetary policy, and not withstanding what the Fed is doing, the combined size of the big four balance sheets should actually grow modestly in 2018, before starting to shrink in 2019. With this in mind it is hard to see credit markets faring too poorly. Our base case is for spreads to be broadly unchanged over the year. Naturally there will be geographic and sector biases to this, which we will try to exploit.
At the top of our list once again are subordinated financials, in particular the maturing Additional Tier 1 sector. By way of reference the $ CoCo index is rated two notches higher than $ high yield, is slightly shorter than high yield at 4.55 years, but yields 369bps over the risk free versus 329bps for high yield corporates. Here we should see some spread compression in 2018, driven by valuations, fundamentals and better technical position as deals are called in 2018. Spreads in this sector are still materially wider than pre-global financial crisis and could easily tighten by another 50bps in 2018.
Second on our list are hard currency emerging market corporates, where spreads are still almost double what they are in investment grade corporates. The EM Corporate Index is 201bps over the risk free for an average rating of BBB and a 7 year average maturity, versus IG $ corporates which are 105bps for 2 notches better rating and much longer at 10.6 years. So some obvious value here, and the sector has real momentum from investors. European ABS should also fare relatively well given its all floating rate, and that Draghi’s ABS purchase programme was not successful. The sweet spot in our view would be in BB rated CLO products that still offer 500 over libor and therefore have some room to contract. Another nugget of value.
For the rest of the market in credit we would just try and keep it short. The credit curve is your friend and the best part of roll down is achieved in the 2 to 4 year area of the curve. A combination of well selected credit, a yield cushion and roll down should trump the rates move against you. Lastly the Brexit premium in £ high yield is overly generous for the more likely scenario of an orchestrated fudge for both sides. The £ high yield corporate index is 346bps over the risk free rate and even shorter than the € index which offers just 227bps for the same credit rating. This makes a little fishing in this cheaper pond sound like a worthwhile exercise.
Within rates markets we still like the Aussie curve, with base rates at 1.50% and 3 year bonds at 2% we think the front end is well protected at least until US base yields move higher, as the carry trade will disappear in 2018. At that point it may be opportune to move out and change to favouring US Treasuries if yields have moved high enough.
So overall, 2018 is likely to be more challenging than 2017, and returns are highly likely to be lower, but strong fundamentals should mean investors can navigate it successfully with a combination of active management and a diligent approach to risk. Our portfolios say much more about what we don’t like than what we do, but that is typical of this stage of the cycle.
Normally this is our last blog of the year, but with forecasts (like Christmas trees) coming out earlier and earlier that is not the case, so I won’t wish you all a Merry Christmas just yet ….but I do hope that ”this time next year…we could all be millionaires….”
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