Weak commodity prices, concerns over growth in China, diminishing returns from central bank easing and fear of a US recession have seen credit spreads over Treasuries adopt a widening trend, writes Goldman Sachs Asset Management's Kate Temby.
Threats of a downturn are overblown. While the recession phase in the cycle will certainly come, expansion in the US services sector and the beneficial effects of low oil prices for consumers and non-energy corporates suggest to us that the probability of an imminent recession is low.
With that in mind, current spreads make corporate credit attractive: since the inception of the relevant indices, investment grade and high-yield spreads have been wider only about 25 per cent of the time.
Of course, the attractiveness of those levels depends on your view of the cycle.
While factors such as the expansion of the debt-fuelled M&A market (which topped $5 trillion for the first time last year) indicate that we are indeed at the late-cycle stage, the sluggish recovery in credit after the 2008-09 crisis will be mirrored by a slow progression to rising defaults.
There is likely to be a rise in US high-yield energy sector defaults this year because of the drop in oil prices, but expect defaults to rise much more slowly than that in other sectors.
However, there is a lot of uncertainty about the length of the cycle, the probability of recession and the events and policy actions that could prompt a rapid change for the worse.
What investors want to know – and what we ask ourselves – is whether corporate credit is the canary in the coalmine offering an early warning of the cycle’s end, like the MBS market in 2006, or whether the positive signals indicate that there is another leg to the current cycle.
Five factors will determine the performance of credit markets in the year ahead, in descending order of importance: commodity prices, global growth, lending conditions, central bank policy and liquidity.
As we have argued, the fallout from commodities is most concentrated in energy sector high-yield names, 20 per cent of which could default in the year ahead, in our view (although across the whole high-yield market we predict a default rate of 5 per cent to 6 per cent).
While we also foresee the possibility of some migration from investment grade to high yield in the energy sector – up to $150 billion of bonds – this is likely to be contained as defaults rise more slowly in other industries, many of which will benefit from the dip in oil prices.
China, the linchpin of current global growth, is an obvious concern as exporters to the country report declining demand, while the US is more of a mixed bag: employment and consumer-related indicators are positive, but commodities producers are suffering the effects of excess supply and exporters face the twin drags of a strong dollar and softening demand.
We are constructive on eurozone growth long-term, although expect to see a modest slowdown this year.
Lending conditions have tightened, driven in the US by the dollar strength, volatility in risk assets and weakness in commodities.
Other indicators show funding availability remaining robust, although the US Federal Reserve’s (the Fed’s) Senior Loan Officer Survey indicates that standards have begun to tighten, with declining forbearance in the face of credit challenges.
While this is an apparent negative, some take the view that this could prevent the Fed from further hiking rates, which would obviously be a credit-positive outcome.
We are well into an era of divergent central banking policy globally. The Fed is sending mixed messages, highlighting slower growth and the strong dollar, but also leaving open the possibility of further rate hikes (although we believe the number will not exceed two in 2016).
Both the European Central Bank and the Bank of Japan are likely to do more easing and while we still think this is likely to be beneficial, questions are being raised as to whether this is ineffective or even harmful in an environment where yields are extremely low.
We are less concerned than others about liquidity. Bid/offer spreads widen when risk appetite declines but trading volumes remain healthy.
The market, understandably, was disturbed by the closure of a US high-yield mutual fund late last year, but we believe that was an exception and are confident that a variety of investors will continue to express views both on individual credits and the wider market.
This collection of factors requires a cautious approach to credit markets in the year ahead. Over the last few weeks, a rise in oil prices and a decline in the US dollar have created more favourable conditions and credit markets have rallied sharply.
While this reinforces our view that elevated spreads offer value, we still think it’s important to watch the canary: the trend of ratings downgrades, the acceleration of defaults and the loss of capital market access by the weakest companies seem to be entrenched characteristics of the current high-yield market, and the feedback loop into broader capital markets and the real economy is likely to be negative.
Longer term, we believe the credit cycle will recover from a purging of weaker issuers and that capital access will improve. Strong market recoveries from distressed levels typically compensate the patient investor that maintains exposure to credit through the default cycle.
Kate Temby is co-head of Asia (Ex Japan) institutional sales at Goldman Sachs Asset Management.