By Tracy Chen, CFA, CAIA
The past decade following the global financial crisis has offered a cornucopia of good returns for most credit investors, despite occasional bumps along the way including the taper tantrum, European sovereign debt crisis, and China’s currency devaluation. The mantra of “buy the dip” has been highly extolled and handsomely rewarded. However, there are many paradigm shifts currently under way:
- Major central banks are at different stages of normalizing their quantitative easing (QE) programs
- The breakup of “Chimerica” forged under the old Pax Americana world order
- The ballooning of corporate credit debt both in the U.S. and emerging market countries
- The rise in populism due to the widening wealth gap resulting from unbridled globalization
These paradigm shifts raise the questions of how credit investors should recalibrate their global outlook, investment strategies, and position their portfolios smartly towards the next equilibrium. It is important to understand the macro story and also identify attractive valuations within credit markets. In my last blog, I covered valuation opportunities by proposing that U.S. structured credit was the last refuge before the next recession. This time, let’s take a closer look at how some of these shifts could affect the macro story.
Central Bank Normalization
After the financial crisis, various asset prices rallied significantly with the tailwind of multiple rounds of global central bank QE. However, Federal Reserve (Fed) normalization and the ballooning of Treasury supply may change this tailwind to a headwind. What the Fed giveth, the Fed taketh away. The Fed’s rate hikes and balance sheet reduction will continue to create a headwind for corporate credit going forward.
The market’s gradual realization that the Fed could raise rates closer to its dots - with inflation more of a risk than markets perceive due to the escalating trade war - can portend additional selloffs in safe haven assets like Treasury bonds. On the other hand, the precarious fiscal situation in the U.S. due to pro-cyclical fiscal stimulus also means Treasury issuance will continue to be high. Chart 1 below shows the amount of U.S. Treasuries has almost tripled to $15.8 trillion from its post-crisis level at $4.9 trillion.
The increase in Treasury supply combined with weak demand from foreign buyers resulting from the negative currency basis presents unfavorable market technicals for Treasury bonds. Consequently, credit investors may find there are limited places to hide as both equities and rates are selling off simultaneously.
As a result, risk parity strategies have been whipsawed, and could experience more pain. With the Fed well on its way to quantitative tightening (QT) and withdrawing liquidity, the European Central Bank (ECB) and the Bank of Japan (BoJ) could soon follow. Chart 2 indicates we are at the inflection point for global central bank balance sheet expansion, which should decline from here. As a result, rich risk asset prices could deflate with the ongoing QT process. The old adage of “buy the dip” lost its validity as the Fed put has a higher strike price with risk management as its mantra.
The Deteriorating U.S.-China Marriage
We are very encouraged by the temporary truce called at the G20 summit in Buenos Aires. The leaders of both countries have started to realize that the possibility of a permanent shift in U.S.-China policy could disrupt global trade, supply chains, and investments, and further dampen business and market confidence. Ultimately Presidents Trump and Xi have recognized that these hardline policies could affect the Chinese and U.S. economies too. This temporary truce is a step in the right direction as officials for each country have signaled that they aren’t likely to let their domestic economies deteriorate for the sake of political theater.
Is the underlying tension between the U.S. and China resolved? China’s economy may have developed to a stage at which the U.S. will view it as a strategic competitor. With a drastically different political system, ideology, culture and world view, finding a resolution may not be easy. In order for this détente to stick, both parties should remain creative and willing to make some compromise to share global power in one form or another. This reset of the U.S.-China relationship is juxtaposed with the structural slowdown in the Chinese economy and the late stage of credit cycle in the U.S. The bilateral strategic competition between these countries and a softening in the Chinese economy carry implications for credit investors.
China's cyclical and structural slowdown could affect commodity markets, as well as emerging markets. China will continue to rebalance its growth model to better align with domestic consumption, upgrade its value chain, and manage the risks from its past largesse of stimulus. The China put also has a higher strike price as Chinese policymakers have a higher tolerance of slower growth. This round of China’s slowdown is self-inflicted by financial de-risking and deleveraging.
With so much debt in its financial system, China is suffering from the diminishing utility of marginal debt. Productivity increases can only come from innovation and private enterprises. With too much government intervention and poor protection of intellectual property and private property, this increasing productivity might be harder to achieve. Incidentally, the emerging market corporates that have tied their fortunes to demand from China may need to recalibrate their outlooks and strategies to account for any slowdown in Chinese consumption.
Ballooning Corporate Debt
As the credit cycle approached its late stage, emerging market corporate debt - most of which is denominated in euros or U.S. dollars - increased exponentially (see Chart 3) thanks to the amount of global liquidity and investors’ chase for yield. The strong dollar, higher U.S. rates, and the weak renminbi collectively do not bode well for most emerging markets. Notably, China’s onshore and offshore corporate debts, other emerging market corporate debt, and U.S. corporate bonds and leveraged loans have grown substantially in the past decade.
In the U.S., there is a tale of two credit cycles with households deleveraging and corporations levering up (see Chart 4 and 5). What is worth noting is not only the increased debt amount, but also the lower quality of the debt, as 45% of U.S. investment grade corporate bonds are rated BBB. Although default rates are still benign, the market is pricing in forward-looking default acceleration as the gap between low default rates and the deluge of leverage is not sustainable. Negative news from companies is coming in one after another.
The selloff in GE bonds is potentially the canary in the coal mine, which may portend the slow unravel of the investment grade corporate debt binge with more credit busts to follow. The market may not be able to absorb the amount of potential fallen angels like GE. It would also be prudent to evaluate how China has lent to emerging market sovereigns as part of its One Belt One Road initiative. Additionally, China’s corporate bond markets have already been affected by the tightening in global financial conditions along with the squeeze of a U.S. dollar shortage.
Populism is on the rise; in Europe, the prolonged Brexit negotiations and Italy’s fiscal situation both pose risks. Italy faces a dangerous crisis of the “Japanization” of Italian debt with majority of domestic ownership via its banking system. Markets may need time to digest the consequences of the end of the ECB’s bond purchase program. European corporate credit markets haven’t offered much in terms of compelling valuations to date. Credit investors interested in timing their entry into this market will have to navigate rising sovereign yields as well as potentially widening corporate spreads. The shift from globalization to populism means that volatility could become a mainstay in both eurozone sovereign and corporate bond markets.
So how should credit investors position themselves and position for the above shifts?
There has been a shift in market structure as financial assets have ballooned while market liquidity has declined and passive management has increased. Popular trades can easily get very crowded in over-long or over-short positions. When trades get crowded, no matter how good that trade is, it may be vulnerable for a sudden turn of fortune.
Credit investors should hunker down and be more defensive and invest in the best refuge market. In my view, the U.S. household sector is the healthiest of the credit sectors due to the continued deleveraging in the 10 years after the financial crisis and the relatively solid U.S. growth. Structured credit includes both mortgage credit and consumer credit sectors. Not surprisingly, both of them have outperformed the corporate credit sector this year, backed by solid housing market fundamentals and heathier household balance sheets. Investing is like fighting a battle. It’s all about timing. There’s a time to be offensive and other times to be defensive.
As the tide of the central bank QE recedes, most credit risk assets will look rich as a result of years of flooding of liquidity and yield chasing. Credit investors should work hard to identify the overvalued risk assets which will deflate without the prop of QE. As safe haven assets like Treasuries are no longer the best hedging tool, investors have to be creative by assessing the overvalued assets to short as a hedge. The corporate bond market is vulnerable at this late stage of the credit cycle given the amount of leverage and the slower global growth.
- Be more nimble/tactical and skeptical of buying the dip. Momentum trades can be easily whipsawed
- Stay in higher quality, shorter duration, floating rate instruments to position for higher interest rate environments
- Watch the flow data to gauge how crowded each trade is
- Leave enough dry powder for opportunities