Inordinate time has been spent on the timing of the first Federal Reserve (Fed) rate rise and its assumed (but disproven) negative effect on government bond prices, but global monetary conditions have been tightening since June 2014 – not December 2015 – in my view.
The dollar has appreciated by 24% over the last 18 months and the premium paid by BBB and BB US corporate borrowers has ballooned by +1% and +2% respectively2 – a 0.25% increase in the target rate is relatively insignificant in the face of this withdrawal and repricing of dollar credit. Tightening dollar liquidity and the very weak global growth outlook has acted sequentially to undermine commodity prices, many emerging economies, high yield debt markets and, more recently, Chinese stock markets.
While China may have taken centre stage in the most recent market drama, I believe the key to navigating 2016 is an understanding that China is a symptom of the problem rather than the cause. While government intervention in the Chinese FX and equity markets may contain volatility in the short term, I expect it to be insufficient to deal with the larger structural issues at play. Chinese authorities find themselves with the unenviable task of needing to weaken the local currency to defend against a worsening domestic growth picture, but maintain enough stability to deter what could become self-sustaining capital flight. It seems likely to me that any further appreciation of the dollar must be met with the sort of adjustments in the yuan that caused so much volatility in August last year and have again as we begin 2016.
One general effect of this dynamic is likely to be that those economies still engaged in policy easing (quantitative easing, specifically) will likely find this less effective, while the Fed will see each act of tightening have a larger effect on its economy, substantially reducing the need for a normal hiking cycle.
Fundamentals matter again
Fundamentally, it’s my view that we have reached the end of the credit cycle in the US. Investment grade corporate issuers, in aggregate, have been increasing leverage for some years now and high yield defaults have been increasing since a low point in June 2014. UK and European issuers, by contrast, have been more conservative with their balance sheets and, while M&A risk and re-leveraging is affecting certain sectors (notably pharmaceuticals, non-cyclical industrials & technology), generally debt sustainability remains relatively better.
We continue to favour banks, particularly in the UK, that continue to de-lever and operate in one of the strongest regulatory environments in the world. While the possibility of a British exit from the EU is likely to cause volatility through the middle of the year, the underlying business models of Lloyds or Nationwide, for instance, are unlikely to change. Similarly, major UK insurers have taken steps to address their new regulatory regime, Solvency II, which began on 1 January 2016 and, alongside generally strong levels of capital and increased visibility, makes subordinated debt from these companies attractive.
Growth being reassessed after Q4
The fourth quarter saw significant downgrades to the global economic growth outlook, including both the United Kingdom and United States3. We will have to monitor whether the current weakness in global manufacturing can negatively impact on what is, so far, a far more resilient services sector. Inflation is low in the UK, US and the eurozone and importantly, longer term inflation expectations have come down to extremely low levels. Subsequently, market pricing for the first Bank of England rate hike has been pushed well back into 2017.
Against this backdrop of anaemic global growth and continued risks from emerging markets, I continue to see high-quality bonds as one of the few asset classes that could provide both an income and real diversification from equity risk in investor portfolios. I see no reason why these trends won’t continue in 2016.
Ben Edwards is manager of the BlackRock Corporate Bond Fund