Summary: This year has started with a pronounced risk-on rally, but macro data continue to signal a coming slowdown. How should investors reallocate risk?
Nobody who celebrated Valentine’s Day in Europe can truly say that the economic situation looks dire. Shops were packed with crowds of lovers buying roses and chocolate, and restaurant queues snaked out of doorways as pair after pair sought their own version of an unforgettable night out.
Such hopes, of course, can seem slightly foolish once the reheated prix fixe is long gone and the credit card bill lands in the mailbox. Given the downcast nature of the macro data we see coming in, we have to wonder if investors presently piling up risky assets might soon develop some post-celebration regrets of their own.
Though it seemed as if we were at the brink of crisis during the last quarter of 2018 when the equity market sold off by almost 20%, such sentiments quickly vanished with January’s rally. But is the worst truly over? Although equity and corporate bond markets are sending bullish signals, the data say otherwise.
Here’s the problem: sooner or later, the market will fall again, and the impact will be much worse for euro investors used to a low-yield environment that pushed them towards riskier assets. These investors are now sitting atop a pile of risk that they would not have been exposed to under ordinary circumstances. They are not only more exposed to price corrections and defaults, but they also have precious little latitude to enter the investment grade space at a reasonable price level as the early-2019 rally has boosted value and lessened the risk/reward profile for IG assets.
The chart below summarises this point very well. As you can see, Citi’s economic Index surprise for the euro area started to fall last September. The Dax index and 10-year German bund yields followed suit. Since the New Year, however, a strange thing has happened: the Dax has shot higher despite sliding economic expectations and yields. Risky assets and safe havens are rallying in tandem, demonstrating a split in investor sentiment. Apparently, market participants are buffering their portfolios in preparation for an economic slowdown even as they pile into risky assets to boost returns.
It seems paradoxical, but the reality is that investors are not yet feeling the impact of the slowdown, particularly in countries like Germany where domestic demand is well-supported by rising wages and household spending. Additionally, central banks are contributing to bullish sentiment as investors believe they will continue to provide support, liquidity and help avoid a sell-off.
Despite all this, we are at the late point of the current economic cycle and there us not much room left to run. The risk of recession means investors do not have many alternatives to turn to when reconsidering their risk allocation.
Because credit valuations continue to be supported by positive risk sentiment, this could a good time to step out of these names and select safer bonds. The hard part will be for investors to find value in safer names, as the rally has kept yields low within the investment grade space. Unless investors are willing to increase their portfolio duration, they are looking at bond returns that are at times below 1%, making the majority of these investments unappealing, and especially so in light of return net taxes.
So what is a late-cycle investor to do?
We don’t believe that all EUR high-yield corporates are bad investments – like any other product, it depends on your point of view. First, investors should consider how long they want to be invested. If an investor is looking to hold until maturity, then opportunities are out there. Looking at the medium term, however, investors should be aware that HY credit spreads will widen in an economic slowdown, and this might constitute a mark- to-market loss if the investor is looking to sell before maturity.
Secondly, an economic slowdown leaning towards recession could trigger a series of defaults of the type that many euro area investors are not accustomed to. It is important that investors make sure they are not caught in anything that points to foreclosure; while higher-rated HY corporates may provide that extra yield versus IG corporates while remaining relatively safe, lower-rated junk may soon prove a trap.
The companies we dislike the most at present are the ones vulnerable to trade war headlines, such as the auto sector, as well as those that are exposed to Brexit but lack a ‘no-deal’ plan. We don’t like subordinated bonds and contingent convertible bonds, and we believe that Santander not calling its perpetual coco bond stepping down from a fixed coupon of 6.25% to a variable coupon of 541 basis points over five-year mid-swaps (XS1043535092) sent a clear message that these instruments are way too expensive.
It also communicated that if the bond steps down to a lower coupon, the bond holder will find themselves trapped in a lower-yielding security as the issuer will take advantage of the situation by keeping the bond running, as they would probably will need to pay more interest to issue new bonds.
So where can investors put their money to work without being excessively exposed to market volatility and the slowdown?
We believe that banks’ senior unsecured bonds look very interesting: they pay an average of 140 bps above the German bund and the sector is better capitalised after post-financial crisis (and 20121 periphery crisis) restructuring.
Bonds of various ratings and maturities can be found in this space, with banks from the periphery appearing to provide a better risk-off reward. In Italy, we are looking at the UniCredit senior unsecured with coupon of 1% January 2023 (XS1754213947) providing approximately 2.57% in yield. If investors are concerned by Italian political volatility, though, they may want to turn to Spain where we find the BBVA senior unsecured with coupon 1.375% and maturity May 2025 (XS1820037270), providing 1.45% in yield. We also see Caixa Bank with coupon 2.375% and maturity February 2024 (XS1936805776) paying a yield of 2%.
Better-rated banks such as ING can also provide a nice pick-up over the bund with the ING senior unsecured bond with coupon 2.125% and maturity January 2026 providing 130 bps over the German benchmark.