19 October 2018
Please find below the notes from GAM Investments’ Weekly Investment Meeting held on 17 October 2018 – this week’s speakers were Michael Biggs, who provided a fascinating insight into the relationship between fiscal stimulus and inflation, and Jeremy Smouha, who discussed the attractive yields currently available in investment grade credit.
- Previously we have stated our belief that the macro environment is quite sound for risky assets. Despite the market turbulence of the last week or so we stand by our view that the growth outlook is promising. Both production and trade numbers continue to rise. And while we may see a degree of weakness in Europe and EM in Q3, we believe these should be temporary factors.
- With regard to the rise in yields, it is the reason behind it which is all important. If yields are going up because growth is strong, the outlook for risky assets is fine in our view. If they are going up because inflation is rising, on the other hand, then there is a potential problem. At present all indicators suggest the former is the case and Federal Reserve chairman Powell also seems to be happy with the US growth story.
- The question then is where does inflation go from here? In the medium term, we believe that is a slight concern regarding the inflation outlook. In the US there has always been a strong correlation between the budget deficit and unemployment. When unemployment rises fiscal stimulus is pushed through and as unemployment comes down the budget is brought back into balance. Currently, however, this correlation has become negative: unemployment is coming down at the same time as fiscal stimulus is being applied. In our view, stimulating growth at a time when there is not much slack in the labour market could cause a rise in inflation in the future, which could threaten the outlook for risky assets. We will continue to monitor this in the near term.
- The only other time when we have seen fiscal stimulus at the same time as falling unemployment was in the late 1960s under President Johnson, which could perhaps be excused since it happened at the time of the Vietnam war. At this time inflation, which had been running very steadily at around 2%, spiked to 6%.
- Other indicators suggest that wage pressures are building. The ‘quits’ indicator (people leaving their jobs confident of finding another) is rising, compensation expectations are up and wages growth has strengthened. However while these things look rather worrying from an inflation perspective they have been partly offset by productivity gains, and unit labour costs (wage growth adjusted for productivity growth) are still running at 2%, dead in line with core inflation. So while there is an inflationary story to watch out for, we do not feel we are at that point just yet. Indeed last week’s CPI inflation number came in below expectations at 2.3% year-on-year.
- Growth has been a good indication of where inflation is going over time, which suggests core inflation could go up to around 2.5%; not enough to worry Powell in our view. Moreover, if oil prices stay where they are we are likely to see inflation on energy prices coming down. So while there is a medium-term inflation concern for the US, we do not believe now is the time to be overly worried from a risky asset perspective.
- In Europe, euro-area wages are rising, but again unit labour cost growth is still below 2% and is not putting any upward pressure on inflation, which remains flat at around 1%. Given strong growth we would expect inflation to rise, as does the ECB, but at this stage it would be a small rise to healthy levels rather than anything to concern policy makers.
- As has been pointed out in the macro overview, economic growth remains solid which provides a favourable backdrop for credit. While equity investors are focusing on corporate profitability against a backdrop of monetary tightening, we are primarily concerned about solvency. This is an important consideration in that it can impact the ability of a company to pay coupon income and return the principal at the redemption date. Solvency does not appear to be an issue in the prevailing environment, especially in respect of the investment grade issuers in which we largely invest.
- While prices are down this year, this follows an exceptionally strong calendar year 2017 and, although past performance cannot be considered a guide to the future, we believe the market has seemingly reached pricing levels which would ordinarily attract capital inflows. For those seeking an entry point, it is worth considering that credit quality is both strong and improving in our view and the Q3 earnings cycle has kicked off well in the US following robust Q2 results in Europe. Certain USD denominated bellwether issues are currently offering a yield of around 7.5% p.a. (EUR issues yielding 6%) which equates to a coupon income of 22.5% over three years. Consequently, even if a point or two is given up through adverse capital movements, this cumulative yield looks very compelling relative to that available on 5 or 10-year government securities and especially cash. Another example concerns a leading Spanish bank which has seen its Q1 2018 issue of a EUR-denominated 4.75% coupon AT1 security fall to a price level of 89, which translates to a ‘yield to worst’ of 6.4%.
- We have witnessed an interesting period of activity in the last few weeks as several companies have taken advantage of the market environment to either re-align their regulatory capital or to refinance their borrowing at lower levels. We have therefore enjoyed bonds being called, or tendered for, at above market rates. For example one UK bank decided to exercise what is called a ‘make-whole redemption’. This provided investors with around 20 points increase in the price of the bonds compared to previous trading levels. A make-whole is a contractual feature that allows a bond issuer to redeem securities early at conditions (which in this case were set out within the prospectus) to compensate investors for the early redemption and the present value of future coupons that the investor will forgo. The reason they chose to pursue this route is that this particular bond, which had an expensive coupon of nearly 9%, will no longer qualify for regulatory capital. We believe this highlights the importance of in-depth analysis of not only fundamentals of an issuer, but also of specific securities – and in particular understanding the terms and conditions of bonds as set out in their prospectus.
- By remaining focused on what matters for our strategy – the strength of our companies – and recognising that much market news or noise, like Brexit, can have a more lasting effect on currency or equity markets than on credit markets, beyond a few weeks, may allow us to take advantage of opportunities. Prices will always oscillate from time to time, but we believe strong companies paying attractive coupon income can provide steady and attractive returns over time.