Tim Winstone, Co-Manager of the Euro Corporate Bond strategy, notes that monetary policy will have a critical role in shaping returns for European investment grade credit in 2018, with financials likely to perform better than most non-financials.
What lessons have you learned from 2017?
My biggest lesson learnt this year is that even when spreads are already tight, they can get even tighter.
Market technicals (the relationship between supply and demand) have been so overwhelmingly positive in 2017 that valuations have taken a back seat. There have been decent flows into the asset class, strong but manageable levels of supply and a central bank buying a significant amount of corporate bonds. Combine these hugely supportive market dynamics with robust underlying corporate fundamentals and European investment grade (EUR IG) credit has surpassed many people’s expectations. While these positive technicals persist, we would expect to retain a long risk bias although we would look to reduce that into further strength. We want to make sure we do not get complacent and that we stay nimble so that we can capitalise on any weakness, should it occur.
What are the key themes likely to shape markets in which you invest and how is this likely to impact portfolio positioning?
The key driver of European investment grade credit markets in 2018 is likely to be central bank policy. In much the same way as 2017, what the European Central Bank (ECB) do with their quantitative easing (QE) programmes – in particular their Corporate Sector Purchase Programme – will dominate EUR IG. We know that they will be in the market until at least September 2018, but it will be important to see what their plans are beyond that date. In that regard, we will be watching economic data for clues.
Geopolitics will also continue to be important. We saw it with Brexit and Trump in 2016; right wing candidates/parties gained ground in countries including Austria and Italy and the Catalans have recently become much more vocal about independence. The increase in nationalist politics is important to watch over the longer term but, for now, I think it is more noise than a structural shift.
Where do you currently see risks within your asset class and where are the most compelling opportunities?
The biggest risk for EUR IG is simply the overall level of valuations. We will probably start 2018 at, or close to, multi-year tights in spread terms and at low yield levels. As a consequence, upside could be limited, with only marginal spread widening needed to wipe out any carry (income) earned. We think there is a reasonable chance of negative total returns if European growth and inflation pick up.
Having said that, EUR IG remains the best technically supported, and most defensive, part of global credit in my opinion and so will likely outperform should there be any broader global credit market sell-off.
We have seen idiosyncratic risk increase over the past six months with the likes of Steinhoff, Syngenta, and Teva reminding us what happens when things do not go to plan. I would expect this to continue and it will be vitally important to be on the right side of these episodes when they do occur. Our deep and global credit research team should stand us in good stead in this regard. We continue to back high conviction, bottom-up trade ideas generated by the team and some of our favourites currently include Telecom Italia, Swedish REIT Balder, and Royal Bank of Scotland. Some of our larger relative underweight exposures currently include Teva, Daimler, and Engie.
We have favoured financials over non-financials in 2017 and expect to continue to position that way into 2018. We particularly like legacy subordinated debt of high quality banks as well as other parts of the capital structure on a selective basis. We think that the relative value that the real estate sector offers still looks attractive and continue to find many opportunities to invest there, particularly by way of the primary market.
Security examples are for illustrative purposes only. Janus Henderson Investors, one of its affiliated advisers, or its employees, may have a position in the securities mentioned. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.