09 Janvier 2017

Blue sky for now

In contrast to the start of 2016 where a large number of dark clouds were looming – China, commodities turmoil, deflation fears, anemic growth outlook, major regulatory confusion in the European bank hybrid capital space – the market environment for the 2017 seems extremely positive. Looking at all the angles of our traditional analytical framework, we see solid and/or improving indicators.

The macro data has been strong in most DM and it seems to have gained additional momentum in the past few weeks. Credit fundamentals remain extremely robust despite some leverage increase in certain market subsets and looser documentation standards becoming widespread in corporate credit. As far as financial institutions are concerned, the transition to post-GFC credit profiles has now been largely completed with very few remaining outliers. On the primary market front, the printing machine works at full steam in most segments, with paper supply being scarce to many investors’ view. Strong market technicals also contribute to support expensive valuations with little or negative net primary supply, continuing positive inflows in credit funds, and large strategic allocations to credit assets by institutional investors. All this is of course magnified – directly or indirectly – by the various ECB asset purchase programs currently in place.

Priced for perfection

With investor risk aversion being at historical lows, we think that rich valuations constitute the only weak link in our credit market scorecard at the moment. In this respect, the price action of risk assets in the last two months of 2016 was striking; whereas global GDP growth consensus forecasts for 2017 barely moved up by ca. 0.1 p.p. during that period, cash credit was up ca. 2%, CDS indices tightened close to their post-GFC lows, and equity markets returned +5-10%. To put it quite simply, we are either entering a new sustainable economic and profit growth phase – not currently forecast by most economists – and current valuations could be justified, or we will likely experience some significant price correction as the market realizes that the perfection it prices is far from being there.

Many risks to bear in mind

Looking forward we are much more concerned and therefore cautious in the way we manage our portfolio, as we see several potential risks to such benign environment. First, increased volatility in risk-free rates and sudden spikes on govies yields are real dangers for global fixed income and financial markets given their current size, duration and trading levels. Just think of the price impact a 50bps rise has on a 10-yr Bund and UST yielding at year-end 0.21% and 2.44%, respectively. Then, there is the risk of an increased yield divergence – in both govies and credit instruments – between USD and EUR-denominated assets. We have highlighted on numerous occasions in this letter our conviction that such large and growing yield gaps are not sustainable and often drive brutal market corrections. Another obvious major risk relates to potential changes in DM CB policies – in particular the ECB – which have driven an unprecedented spread compression through most segments of European credit markets so far. It is increasingly likely in our view that talks of tapering, exit, unwind – or whatever relevant term to use – from the current ECB QE policies will come to the fore. This, in turn, will force investors to refocus on credit fundamentals in their portfolio construction with significant price implications for the market.

Fourth and specific to Europe are risks related to upcoming high-profile elections as up to 4 of the largest EZ members – Netherlands, France, Germany and potentially Italy – will hold general elections soon. Although we do not foresee at this stage any of those countries supporting an EU and/or euro-exit agenda, 2016 taught us to be very cautious with regards to election forecasts and their potential to become black swans for financial markets. That leads us to mention the execution phase of the Brexit referendum decision and its accompanying hot rhetoric as another major risk for 2017. European markets have downplayed the immediate risks associated with Brexit since the June 2016 vote. However, we believe things may well change significantly this year as real negotiations between the UK and the EU will likely start in Q2 and will highlight the major economic risks embedded in the process for the UK. Last, fears of rotation out of credit assets may resurface in two different scenarios: (i) if growth picks up significantly and risk-adjusted credit returns pale in comparison with expectations for equity markets, or (ii) if some of the above-mentioned risks realize, create a negative shock to credit fundamentals and drive investor allocations into safe-haven assets.

Overall, it is really worth bearing in mind, in our view, that some high-impact risks to European credit markets may well materialize in 2017. Given current valuations, market dynamics and risk-returns, it is better to position our portfolio now for such risks than to wait for the storm to begin.


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