Article by Andrew Jackson Head of Fixed Income and Lead Portfolio Manager at Hermes Investment Management 22 February 2019
Some of the more effusive commentators variously described the final quarter of 2018 as a catastrophe and a blood bath – their responses to January’s bounceback have been equally hyperbolic. This has left many investors scratching their heads as to what exactly has changed. My short answer is that nothing actually changed: we just noticed that the emperor was somewhat under-dressed.
We do not see a huge reduction in tail risk despite the easing in some of the rather over-stretched technical indicators. The long-term fundamental issues in the world remain unchanged; we still don’t know what form Brexit will take; the European political backdrop is still far from clear; and the rise of protectionism still hangs like a dead weight around the neck of global GDP growth. We also think it is vital to caution that this sell-off was not the big one; at no time during the sell-off did I feel that it represented anything more significant than a slight correction in the huge bull run that has endured far too long.
While uncertainty does remain, we tread cautiously and looking across our fixed income platform, we have identified a number of opportunities across global markets:
- Emerging market credit has outperformed developed markets on the back of supportive technical and strong fundamentals, reversing the underperformance in much of 2018
- We consider European high-yield corporates to be attractive compared to US high yield and financials
- Low-quality CCC-rated credit looks unattractive given the inferior risk-adjusted returns on offer in a slowing global economy
- The Q4 2018 rally in loans was short-lived with sell-offs ramping up in November and December, driven by instability in US high yield and deepening economic gloom in Europe
- Syndications became harder during Q4 2018 as upward price flexes increased while reverse flexes declined
- Collateralised Loan Obligations (CLOs) were adversely affected by declining sentiment resulting in fewer deals and impaired arbitrage opportunities. The cheapening of collateral is welcome as long as the cost of liabilities is normalised
- Regulatory uncertainty around the implementation of the European Union (EU) Securitisation Regulation has seen the spreads on ABS assets widen, despite their usual resilience in the face of market volatility
- Dutch residential mortgage-backed securities (RMBS) and European auto ABS fared worst over 2018 as the European Central Bank (ECB) capped its purchasing programme
- Investment grade tranches of ABS and CLO remain well-protected in terms of interest coverage and freedom from over-collateralisation
- Subdued deal flow has led to increased competition in certain markets – primarily Germany, the UK and France
- We see continued value in Scandinavian loans, where the originating banks continue to control the market and lender protection rights are relatively strong
- Pockets of value in stable credits are emerging in the UK, combining the benefits of an increased sterling premium and a strong legal environment
- The outlook for UK retail property investment remains bleak, with shopping centres as a sector expected to show negative returns equating to -1.3% over the next five years
- UK offices outside of central London and the south-east are forecast to be the best performers, followed closely by the industrial sector
- We continue to see good value in loans used for capital expenditure investment for transitioning assets in secondary locations
Whilst rumours of the death of the bull market continue, we believe that markets are more balanced as a result of Q4’s slight correction. That does not mean investors should be complacent, the repricing of equity markets is positive for forward-looking sentiment but the speed of the retracement in January is slightly less healthy. Having been battered once in Q4 2018, market participants in less-liquid areas may be less willing to sit on their hands if we see another major test of resolve in the near-term.
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