Mitigating risk as cracks in the credit cycle emerge



Head of Fundamental Fixed Income Darrell Watters highlights the importance of mitigating downside risk as the credit cycle continues to progress in 2019.

What are the key themes likely to shape fixed income markets in 2019?

Inflation will remain a key determinant in the direction of U.S. rates. A steady grind near 2% provides cover for the Federal Reserve’s (Fed) moderate pace of tightening. Deflationary forces will likely remain in play, allowing the Fed to keep rates more accommodative than less.

A continuation of modest GDP growth should support strength in risk markets. If business and – more critically – consumer confidence remain high, and incomes continue to rise, moderate growth is feasible. Residual momentum from tax reform should lead to increased confidence; however, business confidence will need to translate to cap-ex spending to really sustain growth.

Perception of the U.S. dollar’s recovery is stronger than reality, and the greenback has likely reached a near-term top. Recent peaks remain shy of 2015/2016 levels, indicating diminished confidence in dollar stability as market participants weigh the prospects for U.S. growth against the mounting deficit. If growth slows from its already weak starting point and debt-to-GDP surpasses 100%, the dollar could face significant declines in 2019. This is the biggest threat to the benign inflation outlook, the Fed’s gradual normalization and a relatively contained rate environment.

Where do you see the most important opportunities and risks within your asset class?

While the credit cycle may be extended, the end is certainly closer than the beginning. We are monitoring the emergence of small idiosyncrasies for signs that the tides are turning toward a more systemic event. Increasing leverage and potential downgrades in certain investment-grade sectors is of particular concern. Given pending tax refunds and relatively low borrowing costs, new issuance to fund dividend increases, share buybacks and consolidation activity is likely to keep the asset class under pressure. Telecommunications and food and beverage issuers, which require substantial operating capital and already have ample debt loads, may be prone to credit issues, especially if they continue issuing debt to combat industry disruption. Issuers in sectors with fundamental tailwinds and management teams focused on deleveraging will present the strongest opportunities. Stable to higher commodity prices should lead to higher free-cash-flow generation and stronger credit profiles in metals and mining and midstream issuers.

How have your experiences in 2018 impacted your approach or outlook for 2019?

2018 affirmed our view that the credit cycle is advancing, albeit slowly. The first signs of a pullback in leverage emerged, and challenges progressed to investment-grade issuers. While the pace at which the cycle shifts from flat to down cannot be predicted, mitigating risk at this late stage is paramount. As we seek to keep the downside at bay, we intend to emphasize modest position sizes in issuers with steady free cash flow and a commitment to deleveraging, while avoiding opaque business models and companies issuing debt to create shareholder value.

2018 also validated the Fed’s claim to be information dependent. As a result, we too must heed the signs that economic data presents. We will closely monitor inflation, growth and the dollar to help shape our near-term tactical decisions. The ability to dynamically shift our asset allocation in response to economic and credit market signals will grow in importance as the end of the cycle draws near.

Which themes have the potential to redirect markets in 2019? Download our one-pager summary to find out

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