13 September 2019
At GAM Investments’ Weekly Investment Meeting held on 11 September 2019 the speakers were Michael Biggs, who provided a macro overview, Patrick Smouha, who outlined the latest in the developed market credit space, and Fraser Brannan highlighted some interesting systematic themes.
- The Federal Reserve’s (Fed) long-term growth expectations have been broadly unchanged since 2016, but over the past year their long-term policy rate expectations have come down by 50 bps. In essence, the Fed believes that it can achieve the same growth and inflation targets as before, but with a lower neutral interest rate. This is a profound change that we believe should push up all asset prices.
- The expected impact on asset prices was observed over the summer – bond yields fell, equities rallied and credit performed well despite relatively stable spreads. The risk to asset prices from here is that growth expectations are revised down and interest rate expectation struggle to keep pace, or that interest rates edge up without an improvement in the growth outlook. The upside risk would involve an improvement in the trade war narrative and the impact of the China stimulus coming through. In that scenario, the US dollar might weaken and interest rates go flat or sideways. This would create a better environment in both high yield (HY) credit and emerging markets (EM), in our opinion.
- We believe the biggest near-term risk must be a decline in growth expectations, driven by the probability of a US recession. Yield curve inversion has raised recession fears, and the low unemployment levels and declining corporate profit margins support the view that the US is late- cycle.
- However, we do not think a recession is imminent. New borrowing levels are too low to make a recession likely, credit standards have not tightened (according to the Fed’s Senior Loan Officers’ Opining Survey), initial claims have not increased, employment in temporary health services continues to grow. Finally, payroll data indicates household income growth of above 4% in nominal terms.
- In the near term, we hope for an improvement in trade relations between the US and China. Under these circumstances, the China stimulus should boost global growth, which in turn could result in higher US yields and a stable to weaker US dollar. This environment would be tough for US treasuries, but fine for equities. HY credit would like outperform investment grade, and EM local currency debt could outperform EM hard currency debt. Within equities, the trade war narrative improvement and China’s positive credit impulse would most likely benefit EM equities.
- The search for yield has intensified, given there is so much sovereign debt with negative yields – which stands at USD 15 trillion globally currently. The 10-year sovereign debt of Austria, France, Germany, Sweden, Netherlands, Switzerland and Japan all have negative yields, for example. Within European corporates, more than 25% of euro-denominated investment grade credit already has negative yields, and there are even a handful of high yield corporates in negative yielding territory. At the same time, cash is clearly not a viable alternative given negative deposit rates across Europe.
- This interest rate environment in the eurozone, where most investment grade fixed income securities currently yield less than 1%, suggests investors need to take either more interest rate risk or more credit risk. However one alternative is to look for quality income further down the capital structure, particularly within the financials sector, with yields of up to 4% for euro-denominated bank subordinated debt
- We find financials, and particularly European banks, to be attractive for a number of reasons. Banks have strengthened both the quality and quantity of their regulatory capital, increasing their capacity to absorb losses in any severely adverse scenario. They have cleaned up their balance sheets and have overseen a structural reduction of risk-taking activities. This is a highly regulated and liquid market with strong solvency, capital and liquidity ratios. Moreover, Q2 earnings showed a continuation of these trends with very sound earnings. The Bank of England has subjected UK banks to some severe stress testing and all passed – this demonstrates that UK banks can overcome a shock far worse than, for example, a hard Brexit. The stress tests conducted by the European Central Bank also demonstrated that the sector is becoming stronger and more resilient.
- The environment of lower interest rates for longer has put the profitability of the European banking sector under pressure, but in our view this is more of an equity story. For bondholders, we think the impact is neutral as overall fundamentals continue to improve and this has been illustrated by the clear outperformance of banks’ subordinated debt versus equity over the last five years.
- In our view, valuation levels remain attractive. Spreads on subordinated debt have tightened in recent months but remain more than 100 bps wider than they were 18 months ago. The sector also has technical support, with most of the expected supply for the year having already happened. Almost all deals have been heavily oversubscribed and have performed well.
- After some well-documented struggles in 2018, systematic macro investment strategies are proving to be more robust this year. A more dovish sentiment among central banks globally has generally benefitted bonds; equities have also enjoyed positive momentum this year, albeit experiencing volatility in May, amid a spike in trade war tensions, and in August, reflecting growing concerns about the health of the global economy.
- There have been some interesting moves among the more esoteric asset classes that we follow: Hungarian interest rates swaps have performed well over the summer, benefiting when slower inflation ensured that the central bank maintained its accommodative policy stance and dampened fears it would extend March’s tightening move. Forecasts of interest rate cuts in South Africa also supported forward rates in that market. Iron ore prices had been benefiting from supply disruptions during the first half of the year, but this rally was cut short in August when prices slumped over 25%. This reversal was triggered by a gradual re-establishment of supply as well as fears that weak industrial production in China could depress demand.
- We have found that these more ‘exotic’ investment areas provide pockets of idiosyncratic returns that tend to exhibit low correlation to more traditional assets and to conventional Commodity Trading Advisors (CTA) returns. For example, rubber and cheese contracts intuitively should have, and indeed have demonstrated, strong diversifying qualities versus equities.
Source: GAM unless otherwise stated.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.