The first quarter saw an increase in market noise, including an uptick in equity volatility, a change in the leadership of the Federal Reserve, and a barrage of political activity in the US. Heading into 2018, we believed that credit spreads would continue their grind tighter. This past quarter, we ignored the noise and maintained a modest preference for high yield relative to investment grade. This was driven by a positive outlook for the US economy, a continuation of strong earnings, and modest inflation. Combined with the ongoing global search for yield, the environment remained supportive of credit markets. Conversely, we expected the Fed's policy normalization activities to pressure rates upwards. The combination of these factors drove our preference for credit risk relative to interest rate risk.
Recalibrating the signal-to-noise ratio
After sifting through the noise of the past quarter, we maintain views similar to the first quarter. We still prefer credit risk to rate risk, though we anticipate a slightly bumpier version of the goldilocks scenario. We expect fundamental earnings performance to remain strong and believe the equity volatility spike was primarily a technical issue that will not bleed through to credit markets. While staying consistent with our outlook, we made two modest adjustments. First, as high yield outperformed investment grade we have shifted to a more balanced view between the two. Second, as the year progresses we are becoming increasingly concerned about the growing market optimism and some of the risks on the horizon.
While we maintain a positive outlook for the US credit market, we see a number of potential risks increasing as the year progresses. Three of the biggest risks to our outlook are:
- a central bank policy mistake;
- deteriorating credit fundamentals driven by an increase in cost pressures and late cycle behaviors; and
- overly optimistic expectations.
Central bank policy mistake
The markets remain heavily influenced by accommodative central banks in Japan, Europe, and the US. Moving into 2018, expectations are for continued accommodative policies but with a move toward normalization, led by the Fed. Europe is expected to gradually become less accommodative by slowing their rate of purchases, but uncertainty around the strength of the European economy is a wildcard. This gradual pace is predicated on a continuation of minimal inflationary pressures in the global economy. Recent market actions suggest growing concern about inflation and the market is increasingly pricing in expectations for four rate hikes in 2018. We disagree, believing that would be a policy mistake that would jeopardize the health of the current economic cycle.
Deteriorating credit fundamentals
Deteriorating fundamentals could also create turbulence in the credit markets. Companies face difficult comps in 2018 and we are watching for signs of underlying fundamental weakness. We have seen early signs of cost pressures from wages, transportation, and other commodity-based expenses. The competitive business environment could limit companies' ability to pass on those costs to their customers, thereby eroding margins. This comes at a time when expectations have risen sharply. Our view is that the market will punish companies that disappoint, and that underperformance relative to market expectations is a growing cause for concern.
The reaction function in the markets will be crucial. From an aggregate market perspective, if company underperformance becomes pervasive enough, equity markets may become concerned about companies' ability to grow earnings. This could lead to softness in equity prices, and a shift in the market's willingness to take risk. That, in turn, could result in wider credit spreads.
Companies are also susceptible to late cycle behavior. When comps become more difficult to achieve through continued fundamental improvements, companies may take aggressive actions to stimulate growth, such as mergers, acquisitions, major changes to their business plan, increasing their use of leverage, and financial engineering. Many of these late cycle behaviors are ultimately problematic for credit investors and we are closely monitoring this type of activity for signs of excess. The change in US tax law is another reason for concern. There is meaningful potential for companies to use repatriated cash and savings from reduced taxes to reward shareholders. This could potentially erode credit profiles.
Overly optimistic expectations
During the first quarter, economic growth coupled with pro-growth fiscal policies like tax reform and reduced regulation has led to higher earnings expectations. We also see increasing market expectations surrounding economic growth. There is uncertainty as to whether companies can meet these expectations. As the year progresses, a competitive business environment may make it difficult to pass on higher costs to clients and consumers. The achievability of economic growth projections may also be problematic due to increasing base effects and potential pressure on company earnings, such as higher wages, increased hiring, increasing transportation and other input costs.
While these risks do not constitute our current base case our senses are heightened. Many of our concerns are somewhat interrelated—increasingly optimistic expectations, difficult comps and base effects, and concern that this optimism may lead to an overreaction from the Fed in setting interest rates. Bottom line, we are paying close attention to the areas of concern that we have noted, continue to prefer credit risk to rate risk, and believe that investment grade and high yield prospects are more balanced than they were at the beginning of the year.
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