Market backdrop
Despite writing this from a Sydney that is still in lockdown (and expected to remain that way for a while longer) and noting a surge in COVID-19 Delta variant cases circumnavigating the globe, we are surprisingly constructive on the overall economic outlook. Viruses were born to mutate but the various vaccines have, so far, proved to be effective at reducing hospitalisation and death from the various strains.
Recent economic data has generally pointed to a slow but steady recovery. For example, July’s US employment report saw the headline Nonfarm Payrolls (NFP) print at 850k (consensus at 720k) but the unemployment rate rose to 5.9% (from 5.8% in June 2020) and was higher than consensus of 5.6%. This was despite the participation rate remaining unchanged at 61.6%.
In Europe, while the recovery is certainly not as robust as the US – Q1 21 GDP was -0.3% (better than consensus of -0.6%) – June Manufacturing Purchasing Managers’ Index (PMI) still beat consensus, Industrial Production lifted to 0.8% (from 0.4%) and the May unemployment rate dipped to 7.9% (from 8.0%).
It was a slightly weaker story in China, where recent data has missed consensus, slowed from previous months but was still demonstrating that the economy continued to grow at a decent pace. Caixin China Manufacturing PMI dipped to 51.3 in June (consensus was 51.9) from 52.0 in May, Retail Sales in May grew by 12.4% (cons. 14.0%) but down from 17.7%, and Industrial Production printed at 8.8% (cons. 9.2%) but lower than 9.8% in April. Closer to home, May Retail Sales in Australia jumped to 0.4% (cons. 0.1%) from 0.1% in April. The job market remains strong, with May employment jumping 115k (cons. 30k) and the unemployment rate dropping to 5.1% (cons. 5.5%) from 5.5%, even though the participation rate increased to 66.2% (cons. 66.1%) from 66.0%.
Given that economic backdrop, it is widely expected that while remaining supportive, global central banks will become less accommodating by starting to at least think about reducing quantitative easing. While there is a consensus about the above, the jury is still out of the impact on inflation. As such, there is much debate about whether the yield curve will continue to flatten or will the reinflation trade re-emerge leading to renewed steepening.
Credit conditions
We believe that credit fundamentals will continue the improvement seen since H2 ‘20 as the after effects of COVID-19 are fully worked out of the system. In the US, investment grade companies’ profit margins continue to improve, and aggregate earnings before interest, taxes, depreciation and amortization (EBITDA), after falling during 2020, has restarted its upward trend. According to JPMorgan, this has led to a slight improvement in investment grade gross leverage ratios. In May, Moody’s data showed the trailing 12 months global high yield corporate default rate fell to 4.9%, returning to where it stood a year earlier and down from 5.6% at the end of April.
There are a couple of ‘bolting horses’ that could upset the credit fundamentals’ apple cart; debt funded M&A activity, and an increase in dividends and share buybacks. There is likely to be an increase in the former but, for now, management teams appear to be acting conservatively around shareholder-friendly policies.
Looking ahead, the credit outlook is expected to be rather sanguine – which is a positive; boring is good! Moody’s expects the trailing 12-month global high yield default rate to fall to 1.8% by the end of 2021. Furthermore, Moody’s noted, “Default risk should remain low over the next couple of years because of strong corporate profit growth, a booming US economy, and accommodative monetary policy.”
On the technical side of the ledger, investors have continued to allocate towards US investment grade funds and ETFs. Given the negative returns (calendar year-to-date) of most bond indices, this is somewhat surprising but probably highlights the fact that there is comfort about future support by central banks for the bond markets, and some concern surrounding equity valuations.
As for supply, so far this year it has been below 2020 levels and has generally been readily absorbed by the market. Having said that, some Australian new issues have been priced close to fair value and haven’t performed particularly well after issuing. As such, we remain highly selective in which new issues to participate in.
In terms of relative value, we think that generic spreads are tight and generally credit markets (like most others) are priced to perfection. That is not to say that there are no pockets of value left, but like watering holes on the African savanna during a hot summer, it is getting harder and harder to find them as relative value continues to evaporate.
