Download Different Year, Same Problems - BNP Paribas Investment Partners

FOR PROFESSIONAL INVESTORS
QUARTERLY COMMENTARY - Q4 2015
Different Year, Same Problems
January 2016
Overview
The investment landscape of 2015 was filled with a number of
unforseen shocks which resulted in a somewhat unrewarding
experience for most fixed income investors. As we welcome a new
year, unfortunately many of the factors contributing to the low growth,
low inflation environment remain firmly in place.
In this paper, we will take a look at following topics:
• What major themes we expect to see in the first quarter;
• Will global forces continue to present a headwind to the US
economy;
• Will divergence between regions grow; and
• A description of the challenges still in place for already
cheapened asset classes.
Dominick DeAlto
Chief Investment Officer
& Head of Fixed Income
[email protected]
Quarterly Commentary | Jan 2016 - 2
OUTLOOK SUMMARY
Our base scenario assumes that many of the challenges that
markets had to contend with will remain in place with little to no
catalyst for a sea change in global growth. We do, however, believe
that in real terms, certain market leaders, the US and the UK in
particular, will rise toward trend as 2016 unfolds. As a result, the
policy divergence story of 2015 will continue to be in tact as greater
differences in economic health will result in greater divergence in
central bank policy. These differences will necessitate a change
in focus away from the purely “risk-on/risk-off” strategies that
proved successful over the last eight years, toward a more targeted
approach that will differentiate between regions, countries, asset
classes, and even issuers in 2016. We believe that in the US, the
greater risk is that growth will be higher than estimated and that
base effects will cause a welcome rise in inflation. As the effects
of the earlier rise in the dollar and the decline in commodity prices
gradually fade, growth should return to trend in the US. This
could cause Federal Reserve (Fed) policy to be more aggressive
than current forward prices suggest. The Fed did not move in
December because growth and inflation needed to be managed
down. Instead, the Fed merely started on a course to normalize
rates and signal to the market that conditions that once required
profound accommodation were behind us. This suggests that, in
the absence of a flight-to-quality event, rates risk is to the upside.
We believe that the divergence between regions could also grow
larger due to European Central Bank (ECB) policy that will be forced
to deliver further accommodation in 2016. Under this backdrop, we
differ from some who forecast global recession, continued global
disinflation and a meaningful sell-off in risk assets. We caution
however, that while many asset classes look fairly valued or even
cheap, the challenges that have led to these cheapened levels are
still in place. Therefore, we expect to be somewhat targeted, and
far more tactical in how we take risk in the coming year. Of greatest
interest are sectors that benefit from healthy consumer spending,
financials and the somewhat oversold conditions in certain high
yield sectors, the latter of which now offers close to double digit
carry given the severity of recent declines.
THE YEAR IN REVIEW – EVENTS LED TO WORRY
AND VOLATILITY, WHILE THE MARKETS DELIVERED
LESS LIQUIDITY AND RETURNS
Investors were confronted with a number of unforeseen shocks
that caused the investment landscape of 2015 to be filled with
angst. Navigating this landscape was made more difficult given
a pervasive shrinking of market liquidity. The result was an
environment that yielded a somewhat unrewarding experience for
most fixed income investors. Ironically, many key rate levels ended
the year about where they began (Chart 1), but the journey from
January to December proved to be anything but stable. 2015 began
with a rather optimistic consensus of trend growth, particularly in
the US. This optimism was shattered by an unexpectedly weak
first quarter which was largely blamed on unusually cold weather;
an irony that is not lost on us, as the holiday break in New York
just shattered warm temperature records. As the calendar moved
toward the spring, the Eurozone was again paralyzed by debt-crisis
fears, as Greece strained the will of policy makers before seemingly
certain default would again be averted. Simultaneously, Russia
beat the drums of nationalism as it moved to reclaim the Crimean
region of Ukraine. As we entered summer, measures of economic
growth in China began to swoon, causing a cascading shock to echo
across the global commodity complex. Subsequent weakness was
felt the world over as, first commodity exporters, and then the
entire emerging markets space began to tumble again; reminiscent
of the sell-off experienced in August 2013. All the while, investors
had to manage the notion that the Fed would eventually begin its
long awaited “lift-off”, and the potential consequences that policy
tightening could have on an already fragile global market. Despite
a postponement in October, the Fed did indeed begin tightening
policy in December by 25 basis points. Interestingly, this event
had a remarkably muted impact on market participants and
subsequent price levels, likely due to the Committee’s signaling in
the policy statement that future rate increases would be gradual –
a point reinforced by shifts in the Committee’s median policy rate
projections to reflect only 100 basis points of tightening in each
of the next two years. In addition, elements of the statement and
Chair Yellen’s press conference suggest that as 2016 progresses,
sustaining even a gradual path of rate increases will require
evidence that inflation is indeed firming.
Specific to the fourth quarter, attention shifted squarely to key
December monetary policy decisions by the Fed and the ECB.
Expectations for the Fed to begin policy normalization at its
December meeting rose gradually throughout the quarter,
particularly as labor market conditions tightened further and policymakers signaled that global developments had not undermined
their confidence in the outlook.
The Fed delivered what was expected, conversely, the ECB did
not. Accounts of the October policy meeting and comments by
ECB President Draghi and other key policy makers earlier in the
quarter appeared to indicate a view that the inflation outlook had
deteriorated and that inflation risks were further skewed to the
downside. These communications led most investors, ourselves
included, to expect a December easing package that would include
interest rate cuts and a significant increase in the size of the bond
purchase program, to be accomplished through an increase in the
monthly pace of purchases, a six-month extension in the length of
FOR PROFESSIONAL INVESTORS
Quarterly Commentary | Jan 2016 - 3
the program, and possibly an expansion in the range of eligible
assets. We viewed the decision to instead opt for a more modest
stimulus program as a significant blow to President Draghi’s
credibility, both in terms of his communications with markets
and his ability to corral support from more hawkish Governing
Council members for his policy preferences. Going forward, we
suspect that his ability to shape market expectations for policy
through communications has been eroded, and that investors will
more carefully monitor the comments of Council members who
appear less supportive of unconventional policy measures or less
concerned over a weak inflation outlook.
Securitized products such as MBS, CMBS, ABS and Covered bonds
enjoyed a more muted experience relative to corporate credit, but
some areas such as CMBS were also under pressure as investors
looking to shed risk were met with additional supply in the space.
The Fed continued to reinvest pay downs back into the MBS sector
which served to steady demand. This market technical has been
blunted by an increase in net supply and constrained balance sheets
within the dealer community, causing a somewhat unrewarding tugof-war in the space. Commercial Mortgage Obligations (CMOs) were
dominated by late year interest rate volatility despite the positive
influence of lower prepayment speeds.
Chart 1: G4 Rate graphs Jan 1, 2015- Dec 31, 2015
Chart 2: Spread Sector Excess Returns (bps)
100
2.6
US
UK
Germany (RHS)
Japan (RHS)
1.6
39
50
2.4
1.4
2.2
1.2
2.0
1.0
-50
1.8
0.8
-100
1.6
0.6
1.4
0.4
1.2
0.2
9
6
0
Global
Corporates
Global
Industrials
Global
Financials
Global HY
Corporates
MBS
Covereds
CMBS
ABS
-32
-110
-150
-200
-189
-221
-250
1.0
Dec-14
Feb-15
Apr-15
Jun-15
Aug-15
Oct-15
0.0
Dec-15
Source: Bloomberg, BNP Paribas Investment Partners
Spread Sector Review
Despite somewhat higher risk premiums, most spread sector asset
classes recorded a most disappointing 2015 (Chart 2). Given the
considerable magnitude and frequency of risk flare-ups, markets
proceeded with greater and greater caution as the year unfolded.
Lower liquidity also played a part to deepen the malaise that
surrounded the overall risk tolerance of market participants. In
the corporate space, spreads among companies in the energy
complex began to widen as early as December 2014 when oil prices
began to fade. Specifically, those energy companies in the US that
took on greater levels of debt in an effort to increase production
capacity, began to see the economics of their investments
crumble as crude continued its slide. As would be expected, the
carnage in the energy patch moved briskly toward commodity
producers. Weakness subsequently spread to other industrial
sectors, regardless of whether they were commodity producers or
if commodities were merely an input cost. The only safe haven in
the corporate space was the financial sectors which benefited both
from low supply and higher liquidity. As Chart 2 shows, US high
yield was the biggest loser, given the greater exposure to energy
and commodity producing companies.
Source: Barclays Point, BNP Paribas Investment Partners
Emerging Market Debt
Contrary to expectations at the beginning of 2015, EM growth will
actually finish the year lower by almost a full percentage point
to only 3.1%. Growth disappointments went well beyond the
handful of EM countries that actually displayed recession (Brazil,
Russia, Ukraine and Venezuela). To be sure, slowing growth in the
developed space, coupled with a sharp drop in commodity prices
and the tightening of financial conditions were common drivers
of growth deceleration across the emerging space. Additionally,
however, a number of country specific factors drove weakness as
well.
Despite the deterioration of market sentiment towards EM due to
growth disappointment and other negative headlines, EM hard
currency debt still managed to outperform many global asset
classes. EM sovereign and EM corporate, as measured by the
EMBIGD and CEMBI indexes (Chart 3), respectively, outperformed
US equities, global government bonds, as well as global investment
grade and US high yield credit. The impact of higher EM hard
currency carry was able to offset spread widening and movements
in underlying treasury rates.
FOR PROFESSIONAL INVESTORS
Quarterly Commentary | Jan 2016 - 4
Conversely, EM local currency debt was far and away the worst
performing asset class across the fixed income universe in
2015. The GBI-EM local currency bond index returned -14.92%.
This poor performance was driven by EM foreign exchange (FX)
weakness relative to the USD with FX returns contributing the
overwhelming majority the total loss. While we had expected EM
local to underperform hard currency in 2015, the magnitude of this
underperformance was far beyond our forecasts.
Chart 3: EMD Total Return
(%)
EMD Total
4
EM Local Currency
Return (%)
EM Hard Currency
EM Hard Currency Corps
1.30
1.23
2
0
-2
-4
-6
-8
-10
-12
-14
-16
-14.92
Source: Bloomberg, BNP Paribas Investment Partners
2016 VIEWS
Growth and Policy Outlook
Many of the factors contributing to a low growth, low inflation
environment that we have highlighted in the past remain firmly
in place as the calendar turns to 2016. The global economy
continues to struggle under high levels of debt, which serves as a
restraint on aggregate consumption and investment and limits the
effectiveness of monetary policy. Fiscal policy flexibility has also
been constrained in those economies where excessive leverage
is concentrated in the public sector. Meanwhile, potential growth
in much of the advanced and emerging world remains lower now
than a decade ago as a result of lower productivity and labor force
growth. And a large portion of the global economy, including China,
Brazil, Russia, and much of the Eurozone, is struggling to grow even
at potential. In the case of China, growth moderation continues to
impart a disinflationary force on the global economy, particularly
for those countries with a high growth beta to China or significant
import exposure.
Against this backdrop, many major economies are struggling
to achieve the right policy mix. In the emerging economies,
Brazilian policymakers are searching for the right blend of
fiscal and monetary policy given a sharp contraction in activity,
stubbornly high inflation and a challenging political backdrop.
In the developed economies, the Bank of Japan’s (BOJ) ardour for
aggressive monetary easing appears to have cooled as pace on
structural reforms remain modest and the cheaper yen policy has
already taken its toll on household disposable income. However,
from a global perspective the key issues on the policy front remain
in China and the Eurozone.
China’s policy challenge is predominantly structural: the authorities
want to simultaneously liberalise and rebalance the economy
towards a more free-market domestic demand driven model whilst
addressing the legacy of real and financial imbalances that have
built up in recent years (too much productive capacity and too much
debt in certain sectors of the economy). However, that process of
structural adjustment has inevitably weighed on demand and will
continue to do so along the transition path, forcing the Chinese to
pull off a delicate balancing act on the demand management front.
If the Chinese inject too little stimulus then the economy could slow
sharply to the point where the financial imbalances within China
would start to pose a serious challenge to macroeconomic stability
through feedback effects. Too much stimulus and progress on the
long-run goals of rebalancing and reform will stall and potentially
go into reverse – for example, a large depreciation risks a return
to the old model of export-led growth and over-investment in the
industrial sector.
The Eurozone’s problems are more cyclical in nature as it continues
to struggle to recover from the after-shock of the European Debt
Crisis. There is a lot of slack left in the economy, inflation remains
very close to zero and the risk of a slide into full-blown deflation
remains. The ECB Governing Council appears to believe its latest
December 2015 policy announcement of a small deposit rate cut,
buying bonds for longer at the current pace and re-investing as
those bonds mature will be sufficient. However, it seems highly
likely that the central bank’s inflation forecasts will prove too
optimistic and the anticipated acceleration in activity may also fail
to materialise, so the Council will likely be back announcing more
stimulus in mid-year. Unfortunately, there seems little appetite
within the ECB to take the sort of decisive action that would
convincingly solve Europe’s inflation problem. Instead, it seems
most likely that the ECB will further extend the duration of bond
purchases. In the long run, sovereign debt sustainability hinges on
the ECB delivering price stability so the risks if the ECB does get
stuck too far behind the curve should not be downplayed.
Global forces will continue to present a headwind to the US
economy, primarily in the form of weak external demand and
some additional dollar appreciation. Still, the US consumer should
remain resilient, given tightening labor market conditions, low
gasoline prices, a continued recovery in housing and easier access
to credit. In addition, federal fiscal policy should be increasingly,
albeit modestly, expansionary. As such, we expect growth in 2016
in the 2% to 2.25% range, somewhat above trend.
FOR PROFESSIONAL INVESTORS
Quarterly Commentary | Jan 2016 - 5
With the US economy remaining relatively resilient to global
developments, we suspect that a major theme during the first
quarter will be investors coming to terms with the Fed’s resolve to
raise rates incrementally throughout the year should their growth
and inflation forecasts come about. Currently, market pricing
reflects fairly modest odds of a rate increase at the March meeting,
whereas we see such a scenario as our base case given expectations
for inflation to move higher. In fact, fading base effects related to
prior declines in energy prices should boost headline inflation
meaningfully during the first quarter. Core inflation, meanwhile,
should rise gradually towards the Fed’s 2% objective as tightening
labor markets and rising wages begin to exert upward pressure on
services prices beyond just shelter.
While we see additional policy tightening as likely in the first
quarter on the back of continued labor market strength and firming
inflation, the outlook beyond that is quite uncertain. Indeed, both
upside and downside risks to our central outlook appear quite
pronounced. Notably on the upside, this year the economy should
mark a milestone transition to operating without spare labor
market capacity. In fact, with growth remaining above potential
and absent a jump in productivity or labor force participation, the
unemployment rate could fall to 4.5% by the end of 2016, below
most estimates of the equilibrium rate. In this event, wage and
price pressures could emerge somewhat more forcefully than
expected. Importantly, one does not need stronger growth for this
scenario to play out – with potential growth in the neighborhood
of 1.75%, growth around 2% could suffice to eat through remaining
labor market slack and put core inflation on a faster trajectory to
the Fed’s inflation objective.
The above risk scenario is clearly conditioned on global headwinds
easing, in the form of little additional dollar appreciation,
stabilization in oil prices, and positive effects of prior policy easing
elsewhere. In short, a number of pieces would need to fall into
place for US inflation to surprise to the upside. These factors lead
us to view downside growth and inflation risks as also somewhat
pronounced. First, significant dollar appreciation could re-emerge
as a result of additional policy easing by the ECB and other central
banks, particularly in light of China’s recent steps to untether its
currency from the dollar. In addition, China’s economic transition
could continue to impart significant disinflationary headwinds,
especially if policy makers struggle to achieve the appropriate policy
mix. And finally, what increasingly appears to be a manufacturing
recession in the US, coupled with ongoing strains in the oil and
gas sector, could begin to weigh on overall consumer spending and
service sector job creation.
Spread Sector Outlook
Despite a belief that global growth should get some relief in 2016,
we acknowledge that risk markets typically do not show great
correlation with changes in modal economic growth forecasts. They
are instead driven more by tail risk perceptions. In that regard,
spread sectors will likely be plagued by an assortment of tail risk
flare-up fears throughout the year. We remain cautious as a number
of headwinds ranging from continued negative commodity pressure,
weak corporate earnings, and divergent monetary policies will
likely put pressure on global spread markets. If earnings continue
move in their current trajectory given lackluster global demand, it
is likely that spreads could continue to underperform. Additionally
the move from the zero-bound and gradual policy normalization in
the US is likely to cause investors to adjust their allocations more
broadly among asset classes which will weaken a demand dynamic
that has propped up many spread asset classes.
Fundamentally, the overall environment for fixed income risk assets
remains supportive with abundant central bank liquidity provisions
and an ongoing reach for yield; and our core scenario of low growth,
low interest rates and low inflation will mean the demand for
income will persist as traditional yielding assets fail to provide the
required level of income. This will continue to present a conundrum
for investors because the income generating assets are located in
the riskier parts of the investment universe (Chart 4).
Chart 4: Income-Generating assets are found at riskier parts of the
investment universe
10
9
Current Yield (%)
Yield 5 yrs ago (%)
8
7
6
5
4
3
2
1
0
German 10yr
Bonds
Euro Investment
Grade
US 10yr Bonds
Euro High Yield
CMBS
EM local Crncy
Sovereign
US High Yield
Source: Datastream, BNP Paribas Investment Partners
FOR PROFESSIONAL INVESTORS
Quarterly Commentary | Jan 2016 - 6
We continue to prefer European to US corporate issuers on relative
monetary policy and stage of the credit cycle considerations.
Regionally, we prefer UK and European investment grade credit
relative to the US. From an industry allocation perspective, we
are focused on the consumer, which is the one area where we
have observed continued strength. Housing, autos, and other
discretionary sectors should outperform relative to the rest of the
non-financial space.
In mortgage-backed securities a slowly rising interest rate
environment in the US favors the interest only (IO) sector. Longer
term we think the US economy will perform sufficiently for the
Fed to nudge the policy rate higher. This in turn should bias yields
higher and prepayment rates lower which typically bodes well for
mortgage pass-through securities.
To be sure, we are constructive on fundamentals for the first half of
2016, and further believe that central bank policy announcements
at the end of 2015 have provided investors with a sufficient roadmap
to future policy direction. That said, we are less constructive on
the possible direction of spreads.
Investment strategies and themes we expect to employ are,
investment grade/high yield de-compression, regional relative
value, credit volatility option strategies, overweight consumer and
banking sectors, underweight exposure to energy and commodity
sensitive sectors. Additionally asset backed securitized strategies
such as auto and commercial property loans in both the US and
Europe are likely to perform favorably in 2016.
A Special Note on US High Yield
High yield credit is likely to experience increased defaults
concentrated in the energy and commodity sectors, however
US high yield ended 2015 with a yield of 9.28%. This suggests
an aggregate default rate of 4.5%, a full 1% higher than the 10year and 30-year average of 3.5%. This number is skewed by the
implied default rate of 25% in the energy sector. In light of these
overly conservative valuations, we believe other sectors across the
high yield asset class warrant investment consideration. As an
example, consumer discretionary sectors are being punished for
the ills of the industrial sectors, despite a very strong consumer
in the US.
Lastly, one of our principle concerns going into 2016 isn’t whether
there will be continued defaults in the US energy sector, but
whether retail mutual fund and ETF investors grow wary of long
held allocations to US corporates. Fed policy normalization is likely
to cause adjustments to asset class allocations and if outflows
were to increase to a point where forced selling became necessary,
we believe there could be a significant repricing of risk. In this
scenario, considerable caution, if not absolute shorts in credit might
be most effective.
Emerging Market Debt Outlook
Total return expectations for EM Debt in 2016 are in the low single
digits, but given remarkable valuations, there is a chance that
EM local currency markets can enjoy positive returns after three
negative years. Although average EM economic growth is expected
to increase to 3.7% next year, this will largely be explained by an
expectation of modest recoveries in countries that were in recession
this year. Doubts about growth, reduced access to capital, and
the need for structural reform still plague the emerging market
economies; and catalysts for further GDP acceleration is difficult
to find. We expect quite a bit of divergence in growth performance
among countries, but growth in most EM countries will likely stay
below potential given the headwinds ahead, including the impact of
Fed tightening on financial conditions, persistently weak commodity
prices, and the deleveraging pressure coming from an EM corporate
debt overhang.
As such, a more cautious outlook is warranted for investors in
EMD moving into 2016. Despite significant spread widening and/
or currency weakness, market valuations are, in some countries,
still too high relative to expected earnings growth, making them
vulnerable to unpleasant surprises or shocks. The hunt for fixedincome yield is unlikely to abate despite a probable hike in US
interest rates, but we would caution investment in these areas as
there is likely more downside to come.
Currency Outlook
In the upcoming year, monetary policy divergence should resume
between the US and other major G-10 countries, as the US is the
only major country where official rates are likely to rise. The Fed is
expected to raise rates anywhere between 50 to 100 basis points,
while the ECB, the Swiss National Bank (SNB) and the BOJ are likely
to cut rates further and/or engage in more quantitative easing (QE)
during the year, due to a combination of weak economic growth and
a large shortfall in inflation compared to targets. This divergence
should provide another boost of up to 10% to the USD, especially
versus European currencies such as the euro and CHF where
valuations are not excessively low on a Purchasing Power Parity
(PPP) basis. The attractive valuation of the JPY suggests that it
may already be weak enough to keep the currency in a more limited
range versus the USD. If equity markets were to correct during
2016, which is quite possible given the sharp increase in valuations
over the past seven years, the JPY may prove to be an important
safe haven again, given its cheap valuation. In the UK, there is a
possibility that the Bank of England (BOE) may be able to raise rates
FOR PROFESSIONAL INVESTORS
Quarterly Commentary | Jan 2016 - 7
in 2016, though this appears less likely at this time. Furthermore,
the GBP may be undermined by fears over a referendum on the
Euro that could take place as early as 2016, and is therefore not a
favored currency.
With regard to minor G-10 currencies such as the USD bloc, the
outlook for China and commodity prices will remain most important.
The slowdown in the Chinese economy is likely to continue to cast
a pall on the AUD, NZD, and CAD, as well as NOK, as oil prices
remain weak. The recent rift between Iran and Saudi Arabia does
not bode well for OPEC’s ability to rein in production in any way,
opening the door toward substantially weaker oil prices again—at
least in the near term. Ultimately, the fate of global growth and oil
prices is likely to hinge on the ability of the US economy to achieve
more vigorous growth and for Chinese growth to show an inflection
point from the secular decline in place for about five years.
Overall, as we expect 2016 to be a difficult year for risk assets,
we would not be surprised to see choppy conditions in FX as well.
That said, the broad themes of USD strength, euro weakness, and
EM currency weakness should have further to go.
EM currencies are likely to be influenced by developments in
China, to a large extent. Even though EM currencies are quite
cheap in many cases (e.g. BRL), the ongoing weakness in Chinese
growth, idiosyncratic issues in various EM countries, coupled with
a tightening Fed, bode poorly for EM as an asset class.
FOR PROFESSIONAL INVESTORS
Quarterly Commentary | Jan 2016 - 8
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