Economic momentum has gathered pace over the past 12 months, whilst the compensation for risk, known as risk premium, has deteriorated across asset markets.
Valuations are expensive leaving investors highly susceptible to any macro-economic shifts, a tightening of financial conditions, and geopolitical shocks, according to AMP Capital’s Global Fixed Income Head of Macro, Ilan Dekell.
“It’s critical to have as much information as possible on the underlying fundamentals and outlook for volatility, as well as understanding the compensation you are receiving as an investor to accept particular investment risks; in order to stay ahead of market shocks,” Dekell told guests at the AMP Capital 2018 Fixed Income Forum.
Italy is a case in point. Recent elections saw two populist anti-European Union parties form an unlikely coalition in a move that’s raised fears that Italy may attempt to leave the Eurozone, and also raised the risk of fiscal deterioration. This has the credit markets rattled.
“European debt, particularly Italian sovereign risk, is starting to get priced more aggressively,” says AMP Capital’s Hong Kong-based Senior Portfolio Manager Stephen Hannaford.
“Things are nowhere near the level they were during the European credit crisis when banks stopped lending to each other. Yet. But some of the moves we’ve seen in sovereign spreads themselves, on a day to day basis, have been comparable or worse,” he says.
For example, there were stages last month where the widening of Italian bond spreads was worse than any day seen during the European credit crisis.
While fears grow about an Italian exit from the eurozone and the economic rebuild being stymied, in the US and Australia, bond market investors are looking for signs of inflation, to determine whether the global economy is in the late stages of an economic cycle.
AMP Capital uses a fundamentally driven regime frame work to assess bond markets as being in the following phases: reflation, mid-cycle, late-cycle, downturn and recession.
Using a so called “quantamental” approach, that is, quantitatively driven fundamental analysis with a qualitative overlay, the AMP Capital Global Fixed Income team told investors that it appears likely that the market globally is entering a late-cycle regime.
In the US, the shift from mid-cycle, the “goldilocks” period where all assets perform well due to subdued inflation and policy tightening risks; to late cycle, is upon us, In the Eurozone, the regime has moved from largely reflation to mid-cycle, although the current situation in Italy is something that could impact the economic outlook.
In Australia, most signs point to the regime being in downturn, as the Reserve Bank of Australia, continues to forecast subdued inflation, whilst household debt remains the highest amongst developed nations, curbing household consumption.
“What this tells us is there will be rising volatility across the board,” says Dekell. Meantime, credit spreads globally are under pressure to rise.
Regime analysis also suggests that yields globally, particularly in the US, and Europe are likely to be higher, with yield curves to remain under pressure to flatten, while in Australia yields will be sideways to lower.
Once the regime has been assessed, the valuation and carry and rolldown of a credit investment needs to be considered, according to Hannaford.
“You need to be compensated for the default risk,” he told investors.
“We use multiple models with different assumptions for default risk, based on historic analysis, economic variables and market pricing of volatility relative to metrics of corporate leverage.”
AMP Capital uses four methods for valuations, being the Historical Average Cumulative Default, the Statistical Model for Default Rates, Merton model, and Risk-Neutral Expected Default Loss. It’s then important to consider credit risk premia in context of the expected regime, to determine attractiveness of the investment.
Hannaford’s assessment is that credit valuations are expensive, and under most scenarios, expectations for wider credit spreads remains, despite the under-performance of cash credit securities year to date.
“We’re owning credit for carry, in high quality names, with little exposure to credit spread volatility,” he says. “There are pockets where compensation for the risk of default and volatility are simply not high enough.”
One issue that also needs to be addressed is the change in the supply and demand dynamics, that are often hard to model. Models based on historic data don’t take into account these shifts, according to AMP Capital Head of Credit Sonia Baillie.
“If you look at the US, there’s been a huge growth in the proportion of BBBs that are in the US investment grade universe. It’s now 35 percent,” she says.
“You are talking about a big cohort of BBB or BBB- corporate that could become junk bonds or high yield. The concern is what happens to credit spreads in that environment because of the liquidity premia and the ability to absorb that volume of downgraded securities,” she says.
All the more reason to be using a deep mixture of fundamental and quantitative analysis, from the top down and the bottom up.
“Regimes provide insight beyond asset direction, highlighting shifts in correlations and volatility,” says Dekell.
“They are a useful tool to predict macro driven shifts in risk premia, such as credit spreads, but they don’t replace the rigour of bottom up fundamental analysis that a well resourced credit analyst team can provide,” he says.
In Australia, where the Reserve Bank of Australia is expected to keep rates on hold for at least another year, the return outlook for an Australian fixed income index or portfolio remains positive.
“Even though yields are lower than they have been historically, Australia still has higher yields than its OECD counterparts, so on a relative basis it’s still attractive to hold Australian bonds.”
“The US is in a similar position where it’s also attractive, so we are now competing with the US for funds but we are still attractive versus Europe and therefore you have this duration buffer in a negative environment that makes Australian bonds an attractive source of diversification,” Dekell says.
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