By Mark Dowding, Partner & co-head of Investment Grade at BlueBay Asset Management gives his latest view on the markets
The past week has witnessed losses with respect to many financial assets, with stress felt acutely within credit markets. Following on from the VW debacle, last week saw headlines being made by commodity specialist, Glencore, whose CDS spread widened by 400bp before recouping some of these losses. More broadly, liquidity in corporate bonds was heavily impaired into the quarter end with small trades seeming to have a disproportionately large impact on prices.
An example of this was US drilling company, Ensco, whose IG rated bonds fell by 10 points in price following a $3m bond sale, as recorded on TRACE (Trade Reporting and Compliance Engine). Apparently a fund manager was selling a small holding via a BWIC list, which went to 7 banks and this was responsible for the move, which re-priced spreads by 200bp in the absence of any material news flow.
With fear and risk aversion rising, government yields pushed lower, taking Bund yields to a 3 month low. However, the climate of fear showed some signs of relenting at the end of the week following data from China, which seemed to hint at some stabilisation in activity. In Europe, Catalan elections failed by deliver a strong mandate to the incoming regional government with pro-independence parties gaining most of the seats, though less than 50% of the vote.
Portugal goes to the polls this coming weekend, but broadly speaking, reduced political noise has continued to support risk appetite in the periphery. Emerging markets remain far more unstable and despite some marginally positive headlines, Brazil continues to weigh heavily on investor sentiment. Our assessment is that political change there, will only occur slowly and so the fundamental backdrop may continue to get worse, before it can get any better.
Looking ahead, we believe that the recent widening in spreads has limited fundamental justification and should be reversed over time. Economic growth and corporate earnings in Europe and the US remain relatively solid, credit creation remains favourable and default rates remain low (away from the woes in the energy sector in the US).
We look for the FOMC to stay relatively dovish, even if they start to raise rates in December, and see both the BoJ and ECB adding further QE stimulus in coming months in response to disinflationary price developments.
In China, we believe that Q3 may have been the worst of the slowdown and although the backdrop in countries like Brazil is very poor, other emerging markets such as India and Mexico look to be in much better shape. On this basis, we believe that there are many reasons to look for spreads to tighten against the backdrop of very low core government bond yields over the weeks and months ahead.
Within credit, we believe that recent developments should favour a compression trade within spreads, with higher yielding names outperforming lower beta names. The low level of all-in yields has been a limiting factor for demand in high quality credit, but with all-in yields for BBB rated bonds topping 5% in the US and 3% in the eurozone, we see rising appetite for lower quality names at these levels.
This was also demonstrated in an issuer such as VW, where the widening of spreads in senior paper has been similar to the move in more junior hybrid securities, notwithstanding that the latter would typically be viewed in light of having a much larger relative beta.
Without doubt, these are testing times for markets and in the short term, much uncertainty and volatility may persist. However, taking a medium term view there seem to be reasons to become bullish and we should expect support from central banks to prevent any unwanted tightening in financial market conditions.
We have learnt that water on Mars may be in frozen form, yet with winter approaching, there are reasons to believe that Yellen, Draghi, Kuroda and co will want to keep liquidity coming our way.