Credit Still Being Cycled
As we now are well into the Q1 earnings season we have been debating how the current quarter could well be the best for risk in 2018.
As we entered the year we did so with expectations that 2018 would be challenging, far more so than the ultra-smooth benign environment that we experienced in 2017. Our more precise view at the time was that reflation would become a theme but probably not until the second quarter, as the base effects from weak US inflation data from the prior year were replaced by more buoyant signals. As it transpired, the market had these reflation concerns in January and consequently interest rate risk became the source of risk which led to breakdowns in correlations and a period where markets felt quite uncomfortable, a bit like the taper tantrum period in 2013, but with less stress.
In fixed income, rates curves moved higher and credit spreads also widened across the globe – an unusual phenomenon. However, these breakdowns do not tend to last for long and usually repair themselves quickly once a degree of rationality returns. This is why we think that the second quarter could be the period that the first quarter was supposed to be, and could well turn out to be the best part of the year for risk markets. Earnings will be solid, markets are cheaper than they were and the technical position in the market is substantially better after the risk shakeout in Q1.
We believe that credit spreads should contract in Q2, although not significantly, and rates yield curves will grind higher in an orderly fashion as a little extra inflation is observed in the US data. Short(ish) duration combined with smart credit risk should play well in the period.
Notwithstanding this view, we must also respect that markets are expensive and we do not see 2018 as a year for aggressive risk taking, but it could be that the backdrop to Q2 will make it the easiest for market participants.