The underlying themes of the third quarter carry over into the fourth quarter. We see a diverse, yet somewhat balanced set of risks on the horizon. On the positive side for US fixed income markets, we see the ongoing trend of supportive central bank activity and the continuing global search for yield. Conversely, we see softening of underlying earnings trends as companies continue to face increasingly difficult year-over-year comparisons, slowing global growth, and an environment wrought with geopolitical uncertainties.
Analyzing the characteristics of the market through the lens of our investment process—and dissecting fundamentals, technicals, sentiment, and valuation, we remain cautious and retain our modestly defensive outlook for credit. This call is primarily driven by valuation since we remain optimistic that the US economy can avoid a recession in the near-to-intermediate term even with these challenges—albeit at a slower rate of economic growth. If we were to experience a meaningful repricing of risk, we would look to leverage our research capabilities to opportunistically add risk selectively where we remain positive on underlying fundamentals.
There were some positive surprises in both fundamental economic data (Exhibit 1) and company earnings (Exhibit 2) during the quarter—albeit relative to bombed out expectations. Aggregate revenue, earnings and cash flows continued to see positive growth, although at a slower rate. We expect this trend to persist through the upcoming third quarter earnings season. Company fundamentals continue to hold up in the face of these challenges, a trend we also expect will carry on through the fourth quarter.
Exhibit 1: Economic surprises
Source: Bloomberg. As of September 30, 2019.
Exhibit 2: Earnings surprises
Source: Bloomberg. As of September 15, 2019.
Supportive central banks continue to make capital plentiful and inexpensive. Numerous central banks worldwide are reducing rates in an attempt to counter economic weakness (Exhibit 3). Companies have taken advantage of this by refinancing near-term maturities and locking in low-cost financing. Additionally, while succumbing to periodic bouts of volatility, the equity markets have remained resilient, providing underlying support for company valuations.
Exhibit 3: Change in central bank rates from 2018 to 2019
Source: Bank for International Settlements.
Within our framework of examining the fundamental, technical, sentiment and valuation components of the market, we think that technicals will likely be the most positive aspect of the market in the fourth quarter. With the exception of the loan market, US credit market technicals have been supported by continued inflows into the US markets due to the yield advantage offered by US credit combined with expectations for reduced hedging costs.
New issue supply was running behind last year's pace through August, but September saw a meaningful uptick in issuance for investment grade, high yield, and private label securitized assets early in the month before resuming a more normalized pace. We expect this more typical pace of issuance to continue in the fourth quarter for both investment grade and high yield credit.
Sentiment has generally improved with the supportive Fed activity and the positive surprises in US economic data. This generally positive tone has battled periods of volatility as expectations for a resolution to US/China trade tensions and prospects for a resolution to Brexit have been constantly evolving. The ability of the market to absorb September's heavy new issue calendar without meaningful widening was another indication of the relatively positive sentiment towards credit. However, we are less optimistic on the market retaining positive sentiment in the near-term given our outlook for continued slowing global growth, expectations for softening quarterly profits as results are reported for third quarter, and the continued impact of global uncertainties.
Domestic credit spreads remain near the bottom quartile of their recent ranges (Exhibit 4). We view investment grade and high yield spreads as being relatively rich when compared to long-term averages. Despite intra-quarter volatility, spreads for most asset classes were relatively unchanged for the third quarter. We believe the potential for meaningful upside performance from spread tightening is limited in this environment.
Exhibit 4: Asset class option-adjusted spread
Source: Barclays Capital Indices, Barclays Live. As of September 20, 2019.
Securitized credit remains at tight levels, but given our outlook for increased volatility and a repricing of risk, we would be comfortable retaining positions in securitized assets given their lower volatility relative to investment grade and high yield credit. We believe that you can pick up similar total returns to investment grade credit (primarily through carry) with slightly less volatility.
For investment grade credit, the valuations are near 52 week tights, and approaching all time tights. These levels appear even less attractive when adjusting for the increased leverage and duration of the broader investment grade market relative to historical spread data. At the end of the third quarter, investment grade spreads were within a few basis points of where they started the quarter across the various credit qualities. Within the investment grade universe, we would stay relatively neutral in our positioning; in our view, BBB credit remains reasonably priced relative to A-rated credit.
From a high yield perspective, the aggregate spread levels were relatively unchanged, but looking closer, the higher quality portion of the high yield market (e.g., BB and B credits) outperformed, while CCC credits widened over the same timeframe This was consistent with our more defensive approach to high yield credit as investors have remained somewhat defensive, staying up in credit quality within the asset class. Given our lukewarm outlook for the fourth quarter, the less attractive valuations in the upper quality part of the market, and the lack of visibility to a catalyst to drive a rebound in the lowest quality credits, we remain subdued in our outlook for high yield. Given current dynamics we would focus on single-B rated credit while being modestly underweight the BB (valuation) and CCC (idiosyncratic risks) parts of the market.
Risks and Concerns
The US central bank's ability to engineer a soft landing
We remain uncertain as to whether the US Federal Reserve (Fed) can be effective in engineering a soft landing. The ongoing uncertainty caused by trade wars, political strife, and continued softness in the outlook for global growth all serve to increase the difficulty of the Fed's ability to be effective. The market continues to trade as if it has confidence that the Fed can succeed. We agree that recent rate cuts are a step in the right direction, but we are less certain that the Fed can avoid missteps relative to the optimism of the markets.
We saw continued softness in second quarter earnings results during the third quarter reporting period. Similar to the first quarter though, results were better than estimates which had been revised downward heading into earnings season. Exhibit 5 shows the aggregated S&P 500 earnings data by quarter for the past few quarters. We expect the slowdown to continue as companies remain challenged to increase top line growth and experience modestly increasing margin pressure.
Exhibit 5: Quarterly earnings season results
|Y-O-Y||3Q 2018||4Q 2018||1Q2019||2Q2019|
Source: Bloomberg. As of September 30, 2019.
Rising political uncertainty and conflict The US political environment continues to become increasingly uncertain and contentious. The trade and tariff picture remains as clouded as it was in the third quarter, and continues to impact the outlook for capital spending and expansion plans. Meanwhile the House of Representatives has begun to explore the possibility of impeaching President Trump, creating another area of uncertainty. Finally, the 2020 elections loom on the horizon and with a wide range of candidates, the breadth of policy proposals, and their impact on markets, is gaining attention as well. We expect this uncertainty to continue to manifest itself in softening economic data, weakening underlying earnings trends, and continued market volatility. Outside the US, the path towards Brexit remains uncertain and tensions with Iran related to nuclear development activity continue.
In review, global estimates for economic growth continued to soften in the third quarter. The concerns over a spillover into the US, combined with uncertainties related to trade and tariffs, led the US central bank to join in cutting rates. Risk assets held their ground during the third quarter due to a combination of the supportive Fed, earnings not coming in as weak as had been feared, and some modestly supportive positive economic data. Overall, we view fundamentals as being reasonably stable, technicals remaining supportive, sentiment positive but softening, and valuation as being fair to slightly rich.
The strength of technicals and the positive sentiment combined with stable fundamentals and the supportive Fed has led investors to chase valuations past fair value to the point where the market is not appropriately pricing in the risks. Therefore, we reiterate a modestly more defensive tactical position within credit and continue to look for a repricing of risk. Within the overall markets, we retain our favorable tilt towards more defensive securitized assets, a neutral to modestly cautious position in investment grade credit as well as leveraged loans, and a modestly defensive, slightly cautious position in high yield.
While we remain uncertain about the Fed's ability to generate a soft landing, we think a recession and an associated spike in credit defaults remains unlikely in the near-term. Thus, while remaining cautious, we would look to revisit our tactical view and take advantage of wider spreads if and when opportunities present themselves.
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