Investors will discriminate more between corporate issuers given heightened default fears, driving the yield wedge between investment-grade debt and everything below it, and between corporate sectors considered higher quality than their peers.
Sentiment in junk bonds, as well as smaller energy and base metals issuers, is expected to sour further and increase pressure on prices of borderline investment-grade credit. It should also mean investors gravitate further into the crowded trade of prime credit issuers in Europe.
Negative yields to persist across safe-haven European sovereigns
High grade corporates and short-dated government debt yields in core regions – such as 2-year German bunds – are likely to see yields fall further, sustaining the negative yield environment which has persisted throughout 2015.
Meanwhile, the expanded QE program by the ECB, coupled with the mild inflation outlook, will further suppress yields of longer dated peripheral government debt. The ECB’s indiscriminate support for eurozone sovereign debt means further erosion of the yield premium of peripheral sovereigns over German bunds is expected.
Commodity producer recession in emerging markets
The economic slowdown in emerging markets should pose limited risks to sentiment in global financial markets in 2016. China’s potential to further lower policy rates, intervene in FX markets to control yuan deviation, and increase public spending will work to cushion any accelerated downtrend in manufacturing.
However, slumping commodity prices mean inflation-adjusted interest rates for producer nations are still too high, and more monetary easing is expected to help commodity exporters further unwind overcapacity. More corporate downsizing, debt restructuring and defensive M&A activity is expected in 2016 as a result, but we are not anticipating major reverberations in credit and equity markets.
Meanwhile crude oil, along with copper, will continue to succumb to weakness and volatility as the outlook for global energy and metals consumption remains deeply uncertain. Low crude oil prices mean large energy players will attempt to squeeze out smaller rivals by increasing production and market share. Overall, output in crude oil for 2016 is expected to increase as a result, albeit at a slower rate than in 2015.
Meanwhile, gold is expected to remain weak, and could well fall below 1,000 USD/oz next year as real interest rates rise in the US. This downward trend should be sustained throughout 2016 following the Fed’s decision to raise interest rates. Higher rates on cash, coupled with a solid US labour market and a recovering consumer in Europe, undermine gold’s appeal as a safe haven, and indeed makes bunds and treasuries look far more attractive as a risk-off trade.
Broad-based appeal for European equities
With core sovereign bond yields suppressed, further interest rate increases expected in the US, and an upbeat economic outlook for Europe and the US, asset allocation is tilted towards overweighting equities relative to fixed income.
In terms of regions, Europe currently has the broadest appeal, with investors able to pursue a series of strategies on the continent. They can position strategically around Europe’s domestic demand-led recovery via small-cap equities – especially if this is overlaid with a quality screen –and this strategy should minimise downside risk while maximising potential rewards.
Alternatively, large-cap equities also remain a viable play. A cyclical, export-biased portfolio is one way for investors to protect themselves from a tumbling euro, and the grim outlook for overseas trade. UK-based investors should consider hedging their exposure if they wish to invest in eurozone equities because of the downside risks facing the single currency.
For income-seeking investors, eurozone equities paying above average dividends remain an appealing alternative to corporate credits amidst rising default fears, and increasing sensitivity to US rate rises. Compared to its historic trading range, the disproportionately high yield premium equities currently offer over fixed income means they are the standout choice for income.