With economic growth rebounding around the world, compelling credit opportunities might be found outside the U.S.
Credit has enjoyed an exceptionally strong run since the upswing in the global economy since mid-2016. In our view, that trend looks likely to continue, but investors should take a closer look at the overall picture.
“While we expect global growth momentum to remain broadly solid going into 2018, it makes sense to differentiate more across regions given valuations and the different stage of the credit cycle each region is in,” says Chris Kelly, Co-Head of OFI Global’s Global Debt Team.
Indeed, while global credit has been improving overall, some of the most interesting opportunities exist in emerging markets. Within developed markets, we find Europe looks relatively more compelling. The elongated U.S. credit and business cycle, currently eight years and counting, looks increasingly likely to continue into the new year, though late cycle cracks are starting to appear in certain segments.
U.S. stuck in neutral
Growth in the rest of the world is stable or accelerating for the first time in nearly a decade, while the U.S. stays stuck around a 2 percent trend growth rate. Coupled the with relatively richer valuations and higher credit risks in the U.S., investors are seeking more appealing opportunities elsewhere.
While the U.S. media is currently focused on the legislative agenda on Capitol Hill, especially tax reform, ultimately the real risk to the cycle is centered on the U.S. Federal Reserve and the pace of the monetary policy tightening. The Fed is in an interesting predicament. The U.S. unemployment rate is low, wages are starting to climb and the dollar has weakened this year, all suggesting that inflationary pressures may kick in. However, GDP growth in the U.S. remains modest and inflation so far remains invisible. The Fed has signaled it will continue its hiking pace and plans to reduce the size of its balance sheet. With the yield curve flattening, the Fed must proceed with caution. Although it will likely be able to navigate this process successfully and without significant market disruption, tighter monetary policy and a flattening yield curve, combined with sub-par growth, high leverage, and tight credit spreads, could present a risk to U.S. credit market returns. As a result, investors who are habitually underexposed to international and emerging market assets may need to rethink their allocations.
“The U.S. credit rally has been led by energy and metals and mining as commodity prices recovered from the trauma of late 2015 and early 2016, but this may fade going forward just on base effects,” says Kelly. “Outside of these sectors, while top-line growth is back, profitability remains weak and net leverage continues to rise, and in high-yield we see structural problems in certain industries like traditional retail and wireline telecoms.”
Possible boost for corporate bonds
Corporate bonds have been the asset class of choice for U.S. fixed-income investors for some time, and many investors believe it could get a further boost from recently passed tax reform, which reduced the statutory corporate tax rate from 35 percent to 21 percent. “While we believe tax reform could be a boon to investment-grade credit, the deeper you go into U.S. high-yield the less income there is to tax, and the reform also limits the deductibility of interest expenses at 30 percent, which is a negative for companies carrying higher debt,” says Kelly. “All said, U.S. credit should be viewed at most as an income-generating investment as further price appreciation will be limited, and you will need to pick your spots carefully.”
A measure of diversification out of the U.S. may prove beneficial—particularly into emerging markets, where credit opportunities continue to improve and where dollar bonds can offer better value for those investors seeking higher potential total returns. Emerging markets suffered shocks much earlier than the U.S: The May 2013 “taper tantrum” and its aftermath resulted in sizeable capital outflows, a sharp weakening of currencies, and a slowdown in growth versus the developed world. Along with turbulence in China, and the downturn in commodity prices, this culminated in recessions in some of the largest countries, such as Brazil, Russia, and Nigeria. The silver lining was that these shocks elicited positive policy responses across much of emerging markets, including a strengthening of macroeconomic policy frameworks and structural reforms. With the tailwinds of weaker currencies and a recovery in commodities prices, emerging markets have seen a rebound in growth, and a rising growth differential versus developed countries, which is expected to continue into 2018 even as commodity prices moderate.
Lower inflation provides bankers flexibility in emerging markets
Inflation has been trending lower across emerging markets, providing central bankers with greater flexibility to enact supportive monetary policy that stimulates local economies if needed. With real yields approaching cyclical highs, this is again attracting capital inflows. In sum, the improvements in emerging market fundamentals make these economies significantly less vulnerable (than in 2013 and 2015, for example) to capital flight as the Fed raises interest rates. Lastly, while Chinese growth may slow in the months ahead as the authorities focus on financial stability, hard landing risk seems unlikely in the near term. “We believe global funds still remain underinvested in emerging market credit and expect inflows to continue, even if at a more moderate pace” says Kelly.
In Europe, growth has delivered positive surprises for much of the year, and the economy has outpaced the U.S. for the second year running – and yet, it is at an earlier stage in the credit cycle compared to the U.S. Earnings are picking up, but company management teams still remain more conservative and focused on preserving strong balance sheets. This has resulted in a more favorable trajectory of credit metrics, such as net leverage and interest coverage ratios, than in the U.S. Europe has carried a higher political risk premium in recent years with fears over the sustainability of the European Union, and rising populism. However, elections in Europe this year have yielded market friendly results and a better political environment. “Investors who paid too much attention to European politics may now be starting to appreciate the sound economic and earnings recovery taking place across the continent,” says Kelly. “We’ve lived with Europe as a material risk for years, but that risk hasn’t materialized, so with recent economic improvements European credit is performing well.”
After years of monetary policy support for the rocky European economy, the European Central Bank (ECB) announced its plans to further taper its asset purchase program, starting in January 2018. However, the program still remains dovish in design and monetary policy will remain accommodative relative to the U.S. Indeed, ECB’s forward guidance suggests that policy rate hikes will not come before 2019. “We see both favorable macro fundamentals and bottom-up strengths driving European credit, and prefer holding it to European government bonds or U.S. credit,” Kelly adds.
Learn how we challenge expectations with our Emerging Markets Local Bond Strategy.
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