Song remains the same in 2019? We think not
January 28, 2019
In a December 2017 article, we posed the question whether investment grade (IG) credit could buck historical trends and generate positive excess returns for a third year in a row. Our view was supported by improving fundamentals and positive technicals, which had driven strong performance in 2016 and 2017. In addition, we believed that benefits of corporate tax reform would be a tailwind in 2018, albeit with bouts of volatility and geopolitical risks involved. Tax reform has no doubt had a positive impact on corporate credit across almost all sectors. Lower corporate tax rates have boosted earnings and foreign cash repatriation has reduced issuance, particularly within the tech sector.
But as we enter the new year, it’s clear that 2018 did not extend the winning streak to a third year. In fact, quite the opposite has happened as credit risk repriced significantly in 4Q18. Specifically, total returns for IG credit (as measured by the Bloomberg Barclays US Corporate Index) in 2018 marked the worst annual performance for corporate bonds since the financial crisis in 2008. Concerns over global growth, trade conflicts, domestic equity weakness, mixed corporate earnings, US Federal Reserve rate policy, Brexit negotiations, and the Italian fiscal deficit all weighed on the credit market, offsetting the fundamental story. The ongoing trade dispute with China, in particular, was arguably one of the more detrimental, and surprising, influences on market sentiment in 2018. It is posing a risk to global growth prospects and has already had real consequences for credit fundamentals for select issuers. Recent high-profile examples1 from across the US industries include:
- Whirlpool reported disappointing second quarter results, while Harley Davidson also lowered future guidance, both driven by demand weakness and raw material inflationary pressures (steel).
- Autos was another sector that experienced weakness on the heels of tariff driven raw material cost increases. Specifically, Ford reported largely weaker than expected 2Q18 results and the company cut its full year guidance for 2018 amid recent pressures.
- Apple recently cut its revenue outlook for the first time in two decades due to weaker demand out of China.
- 3Q18 results from 3M missed consensus revenue estimates and cut its FY18 EPS outlook amid slowing demand for autos in Europe and weakness in China along with rising material costs.
In short, 2018 delivered on our expectations of it being a transition year, with bouts of volatility. However, Trump’s on again/off again attack on global trade, along with levels of fear and investor anxiety that pushed corporate credit spreads to their widest levels in several years, were beyond our expectations.
We certainly appreciate the abounding risks in the current environment given the late stage of the credit cycle – especially the Fed unwinding its accommodative policy and the ongoing trade wars that have the potential to derail global growth. However, the recent volatility associated with these fears has pushed credit valuations to levels that we believe more fully reflect these risks. Thus, in our opinion, US IG credit spreads have become disjointed from fundamentals, and at multi-year wide levels reflect a much better opportunity when balancing the aforementioned risks. If the Fed can engineer a soft economic landing and trade wars do not escalate, we believe US IG valuations entering 2019 represent opportunistic levels for investors who maintain a clear focus on individual security selection and commit to deep, bottom-up fundamental research.
Supply side technicals have been supportive of market conditions as gross supply has diminished year over year. Full-year IG supply came in at $1.24 trillion2, down roughly -10% year over year, as tax reform and the effect of repatriating offshore cash is reducing the need for companies to issue additional debt. The technology sector in particular is a good example of the effects of tax reform on issuance, given the significant amount of offshore holdings in the space. Technology issuance for 2018 totaled $21 billion, compared to $148 billion of total issuance from this industry in 20173. Market volatility has also contributed to reduced supply levels with some issuers standing down from the market and pushing opportunistic deals into 2019.
2,3 Data source: Bank of America
Demand side technicals have been a different story as investor appetite for credit has weakened considerably amid a number of factors: increased hedging costs that have reduced foreign demand for USD credit, repatriation of overseas cash that has reduced corporations’ needs for shorter dated securities, and a flatter Treasury curve that has reduced the attractiveness of longer-dated corporate yields. We see some potential for alternative buyers to fill this void as rising all-in yields attract domestic pension funds, while regulatory changes in Taiwan could increase demand from Taiwanese insurance companies. But with a stronger USD and continued accommodative policies outside of the US, we don’t expect FX hedging costs or foreign demand to materially improve in the near term.
While technical conditions remain lackluster, corporate fundamentals remain supportive as sales momentum continues to be strong, earnings growth remains healthy (although likely to have peaked), free cash flow generation continues to be solid (a key driver of credit quality), and tax reform has a positive impact. Upcoming earnings for the full year 2018 are expected to come in near 20% growth year-over-year, a level that will likely be difficult to match in 2019. However, even the 6.5% consensus estimate4 for expected earnings growth in 2019 would be fundamentally positive, in our view, at this point in the economic cycle. Gross leverage and interest coverage have shown some improvement from earnings growth but remain weak given we are in the late stages of the expansion cycle and earnings growth will likely slow as the benefit of tax reform fades.
4Data source: FactSet
When spreads begin the year ~150 basis points or above, excess returns are most often positive*
Start-of-year spread vs. the calendar year-ahead excess return
Since 1990, 10 years have started the year with spreads more than 150 basis points. Seven of those years produced positive excess returns, while 3 produced negative. Of the 19 years since 1990 that began with spreads less than 150bps, 10 produced positive excess returns, while 9 years produced negative. Generally, only “tail-risk” events have caused this trend to break down.
Note: for purpose of scale, not every year is displayed.
Data source: Bloomberg
2018 was a year that most credit investors would like to forget, and we believe that some of the same downside risks that impacted credit performance in 2018, such as trade disputes and Fed policy, will persist into 2019. That said, we do believe that credit performance will improve in the new year, as revenue, free cash flow, and earnings growth remain supportive. We simply expect to see growth that is off the highs, and valuations become more justified relative to the backdrop.
Broadly speaking, we expect a 2019 credit environment characterized by:
- tax reform exuberance that fades
- spreads that tighten modestly
- IG credit generating positive excess and total returns based on significant repricing of credit risk in the fourth quarter of 2018.
The views expressed represent the Manager's assessment of the market environment as of January 2019, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Market risk is the risk that all or a majority of the securities in a certain market -- like the stock market or bond market --will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
Past performance does not guarantee future results.