Slowing growth in China, plummeting commodities prices — particularly for oil — and disappointing retail sales figures in the U.S. helped trigger a worldwide market rout in the first weeks of 2016, but these are not the issues that will dominate investors’ minds as the year unfolds, according to global heads of credit research at several prominent firms.
“Clearly, 2016 has seen an inauspicious start for risk markets,” observes J.P. Morgan’s Stephen Dulake, who is based in London. “Volatility has been and remains high, and it’s hard to see this declining meaningfully in the near term. While Chinese macro concerns and falling commodities prices have been factors, they’re not the only factors. On commodities it’s not just that prices have fallen, but rather now that they’re forecast to stay lower for longer.”
Moreover, policymakers’ efforts to jump-start growth and investment are proving largely ineffective. “Negative interest rates are increasingly seen as problematic, particularly for banking sector stocks and credit, such that further mooted central bank policy action is not impacting markets positively in the way that it used to,” he explains. “Furthermore, while it’s at different stages in different market segments, we’re also talking about a credit cycle that is very mature. Quite frankly, it’s hard to see a quick fix on any of these fronts.”
Dulake’s counterpart at Bank of America Merrill Lynch, Michael Maras, believes investor attention will soon turn to the European Central Bank.
“Quantitative easing by the ECB remains the major focus point for bond markets this year,” he insists. “We expect a third round of quantitative easing by the second half of this year as the commodities story makes it hard for the bank to achieve roughly 2 percent inflation. This should keep government bond yields very low.”
There’s even a chance that the central bank could expand its asset-purchase program to include corporate bonds, Maras adds, “but I feel that they have enough government bonds to buy at the moment. However, if they did buy corporates as part of QE, it would be a major tightening force for European credit.”
With 2016 already shaping up to be a year of surprises, it’s a safe bet that money managers will look to the sell side for assistance in understanding each new development. When it comes to research on Europe’s bonds and similar instruments, no firm is considered more helpful than J.P. Morgan, which for a sixth consecutive year tops the All-Europe Fixed-Income Research Team, Institutional Investor’s annual ranking of the region’s most highly regarded credit analysts and strategists. The bank’s team-position total surges by nearly 50 percent, from 14 to 20. Its analysts rank in every sector that produces publishable results but one: Investment-Grade Strategy.
BofA Merrill, which shared the winner’s circle with J.P. Morgan last year, slips to the No. 2 spot even though its total also increases, to 17. Barclays and Deutsche Bank repeat in third place with 11 spots. Sharing fifth place, with five positions apiece, are Citi — which rises two rungs after picking up one spot — and Royal Bank of Scotland, whose total holds steady. Survey results reflect the opinions of more than 750 investment professionals at 373 buy-side institutions that collectively manage an estimated $6.4 trillion in European fixed-income assets.
Deutsche Bank’s James Reid pilots the No. 1 team in High-Yield Strategy (for a fourth year running) and the No. 2 crew in Investment-Grade Strategy (for a second year in a row) and co-leads, with Francis Yared, the squad on top in Fixed-Income Strategy — the group’s sixth straight sector-topping appearance. He also believes that all eyes will be on the central bankers.
“It’s inevitable that the ECB will add more stimulus at their March 10th meeting,” says Reid, who is based in London. “Notwithstanding the recent financial market stress, you have an inflation target that the ECB is falling very short of. The bigger question is whether they’ll add anything that helps restore confidence in the region’s banks. Without a functioning banking system, their policies struggle to be transmitted through the economy, so it’s in their interest for the current fear over the sector to be reduced.”
Despite the turmoil that has accompanied the new year, Reid and his associates are relatively upbeat. “We have long targeted 2017 as the next problem year, due to increasing risks of the cycle turning over,” he notes. “We stick to this view even if market levels so far in 2016 raise the risks of a more imminent problem for the global economy and markets. For now we think we’re late cycle but possibly have another year left before it turns over. If correct, European credit should rally back from these elevated levels. The risks are high, though, so we would have sympathy for those with a more defensive outlook given the problems we see slightly further out.”
As does his colleague Caio Natividade, who guides the Deutsche Bank squad from second place to its first appearance atop the Quantitative Analysis roster. “Most of our models are not designed to predict the future and instead focus on adapting quickly to ever-changing markets,” the strategist says. “At the moment, we are defensively positioned. While flat equities, we are short commodities and emerging currencies, while long bond futures. This exposure concurs with the cautious view outlined by our macro strategists, who point to various regional risks acting together to generate broad market risk aversion.”
Although many investors may welcome additional quantitative easing, looser monetary policy will further depress the euro against the dollar, cautions Hans-Guenter Redeker, who guides the Morgan Stanley squad from third place to its first appearance at No. 1 in Currency & Foreign Exchange.
The regional currency was trading at 1.09 to the dollar in mid-January, and “we predict EUR/USD reaching 1.00 by the end of 2016, weakened by the ECB’s continued money print and rising U.S. rates,” he says. “But volatile capital markets should prevent EUR/USD from falling hard.”
Investors would do well to consider the krona, the London-based strategist adds. The possibility that Sweden’s central bank might shift to a dual-target approach — one that focuses on employment levels as well as the inflation rate, similar to the strategy employed by the U.S. Federal Reserve — “suggests the Riksbank may provide less monetary accommodation compared to what is currently priced in the market,” Redeker believes.
