Stephen Thariyan, Global Head of Credit, analyses the recent moves in credit markets, exploring the outlook for European and sterling corporate bonds. In addition he discusses how long the Trump rally might last, inflation expectations, improvements for banks, Brexit developments and issuance trends in 2017.
How did corporate bond markets perform in Q4 2016?
Performance was mixed and very dependent on which part of the ratings spectrum you looked at. Investment grade markets suffered mainly on duration, as growth numbers came in strongly and inflation expectations rose. The election of Donald Trump accelerated matters and generated a move in the yield curve that has not been seen in many years.
Essentially, total returns were down in Q4, driven by duration for investment grade credit in the US, Europe and the UK. In the high yield markets the data that led to expectations of stronger growth and a stronger equity market, also led to stronger returns. This was particularly the case in the US, where oil prices stabilised and earlier concerns about the lower oil price disappeared. Hence, investment grade was weaker, with negative total returns, whereas high yield was the exact opposite.
Do you think the Trump rally will continue?
This will depend on the delivery of policy. At the moment there is a lot of rhetoric — every time Trump speaks, something moves, particularly in the Foreign Exchange markets and forward curves. I think the concern is the timing of delivery. Even if Trump comes up with policy and implementation, it depends on how quickly that can result in a change, and certainly a lot has been priced in already.
One thing I would say is that with the movement in the yield curve that we have seen, it has become a better environment for banks. Bank earnings have generally been better for many reasons, not least trading. The trading environment for bonds has improved and banks have generated quite strong returns. The classic way of making money for a bank has also improved with a steeper yield curve. In summary, it depends on how quickly Trump can deliver and how much confidence people have in those plans, but they have priced in a great deal so far.
What are the current inflation expectations and the impact on credit?
I believe we have already seen the impact of inflation expectations on credit, in terms of a Trump inspired movement in the yield curve, growth, inflation, the actions of the Fed and the renewed interest in the US Federal Reserve in terms of its moves this year.
The impact is across different markets. Credit has historically, especially in the high yield world, done quite well as we start to see rates go up. I think it depends on how effective Trump is, and how effective the central banks continue to be – both the Bank of England and the European Central Bank (ECB).
In summary, there’s an expectation for inflation to go up; the speed and the scale of which is just too uncertain. The expectation is that we will see growth that has an impact on credit – ultimately a positive impact, but it depends on the speed of central banks in reacting to events.
Issuance trends in 2017?
This is a mixed bag and I would say that there is no real consensus on what we will come across in terms of the net issuance in sterling, dollar or the euro markets. If we are talking about a fairly benign environment or one without a great deal of change for issuance based on last year, other factors will drive our markets. It is really about value, expectation of yield change and quality of credit.
What are your key factors when assessing the outlook for European credit?
This depends on a number of issues. Firstly, the impact of every other market — mainly the US. We have seen a movement in the yield curve in Europe based on Trump inspired politics and policy out of the US. We have also seen the strong buying programme from the ECB falter slightly or calm down, and there is an expectation that they may taper at the back end of this year. Tapering usually brings with it concerns about where the market goes from there. Two to three years ago we saw the taper tantrum in the US and the market sold off dramatically.
There is also a relative value issue, in terms of what Europe offers versus the sterling and the US markets, and we have seen outflows generally from the asset class within our own funds. That said the market has started quite well in Europe this year, nothing dramatically has changed and we expect this to continue and credit quality to remain fairly solid. The only issue with the European investment grade market is that it does not currently offer a lot value compared to the other markets.
Sterling corporates have performed well in the aftermath of Brexit. Do you see this trend continuing?
Sterling corporates have done well, inspired by the Bank of England with its QE programme and the fact that Brexit has not really had the impact that people thought it would. I think as more news comes out, we will see certain claims to have been unfounded, as it will take an awfully long time before we see the true ramifications of Brexit.
From a relative value perspective, given that the US market has done well and Europe offers little value, the sterling market offers a good place for investors to go to. Consequently, as investors rushed to the market, value has come down slightly. It has performed well in the first month of this year and we are still seeing good returns in our own funds. There may, however, be limitations to this move as value comes out, and as we see what Trump will do or where we see shifts in valuations elsewhere.