The high-yield bond market could be at a turning point, but will it prove a tactical setback or something more serious?
As always, time will tell. The recent support for risk assets appears to stem from the fact that global economic growth still looks good, with multiple regions growing at the same time. Furthermore, trade and optimism are strong, as illustrated by the chart below which shows the Baltic Dry Index (providing an assessment of the price of moving major raw materials by sea, and therefore a view on global trade) and the U.S. manufacturing purchasing managers’ index.
However, the global money supply looks to be rolling over (as the chart below highlights), which we think could lead to cooling of demand.
The positive connection between the benign economic growth outlook and risk assets appears to us to have been strong. As the chart below illustrates, the high-yield bond market total-return index has risen 30% from its lows of February 2016. With central banks reducing their monetary stimulus, and in some cases tightening monetary policy, the possibility of these risk assets losing momentum and even pulling back sharply must be significant.
Our main concern is that in some instances corporate leverage is very high. In such cases, it may not take much of a hit to operating profits for those companies which are currently ‘darlings’ of the equity and high-yield markets to become ‘dogs’. This means, we believe, that credit risk for a number of individual companies is high even if the overall market has seen buying support and there are limited concerns about wholesale defaults.
After such a good run, and where risk levels have risen, we believe it is prudent to trim back exposure. Across our fixed-income strategies, we have been reducing credit exposure while still participating in the market. This may mean avoiding sectors where operating profits are challenged, as well as individual companies that have too much leverage or whose valuations appear stretched.
Normally, increasing exposure to government bonds can be beneficial as risk assets retrench. However, given the tightening of monetary policy, we see the major government-bond markets currently as offering little in the way of returns. Therefore, we are maintaining a higher cash weighting. At some point, we anticipate that the potential decline in economic growth is likely to start to become the main driver, which we think should enable government bonds to rally.
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