AXA US Short Duration High Yield Bonds strategy manager, Carl ‘Pepper’ Whitbeck, takes a look at what he expects 2018 to deliver in terms of monetary policy, inflation and investment opportunities…
No-one is going to accuse 2018 of getting off to a slow start. Less than a fortnight after the US equity market’s January high, investors had to contend with one of the steepest sell-offs for some time.
But the positive US economic backdrop belies the market’s volatility. We still have low, albeit slowly rising interest rates and GDP growth at around 2% to 3%.*
In addition, corporate earnings appear to be in good shape and even look poised to grow, particularly on the back of the new tax reforms. Broadly speaking, the overhaul should reduce corporate tax bills and increase after-tax cash flows.
One of the most pertinent concerns, at least at the start of the year, was high-valuations. But the recent market wobble has helped, to an extent, to alleviate this issue as we have witnessed yields rebound from their January lows, injecting some fresh value into the market.**
Interest rates and inflation
More generally, one of the main issues on investors’ minds is interest rates – and how quickly they could rise from here.
A hint of wage inflation is coming through. On an annual basis, consumer prices increased by a greater-than-anticipated 2.1% in January and we believe the market has started to price in a stronger chance of the US Federal Reserve raising interest rates four times in 2018.***
But I believe three hikes is more realistic, as I don’t feel the Fed has – or will have – the room to move by more this year. I am not that concerned about rising rates from a fundamental perspective in regards to the high yield market. However if rising inflation does spook equity markets, it could impact high yield given that the two asset classes tend to be quite correlated, although equities generally tend to be more volatile.
Many fixed income asset classes have naturally been impacted as interest rates have moved higher, but overall we believe the environment remains favourable for high yield. Historically, high yield has generally been able to better withstand a tightening of monetary policy because it is a relatively lower-duration asset class due to the callable nature of most of the bonds on the market.
Additionally, spreads are typically inversely correlated with interest rates, so in a rising rate environment you often see spread compression, which can affect the negative price impact from the move in interest rates.
A more favourable backdrop?
I’m not, however, expecting to see a lot happen with spreads over the course of the year. I expect the default rate will remain below 2% and believe a rising rate environment should earn us a coupon-like return.
Short duration is very well-suited to this sort of backdrop because we see a lot of natural turnover in the strategy, as issuing companies are taking their bonds out of the market through corporate actions and maturities. This means we are generally seeing natural cash-flows come back into the portfolio, which are then reinvested, so our strategy has the ability to adapt to a rising rate environment.
We need to be cognizant of oil prices too, after all, energy is the largest industry in the high yield market.****
Our short duration strategy is structurally underweight the sector but if oil prices were to fall below the $50-a-barrel mark, we’d naturally need to keep a close eye on the situation.
But importantly, the balance sheets of energy companies in the high yield market today are healthier than they were several years ago. Therefore, I would expect the sector to be much more resilient if we did endure a decline in crude prices.
In terms of where we are currently finding opportunities, the healthcare sector has become an interesting hunting ground.
Previously a more defensive, priced-for-perfection-entity, healthcare policy has more recently been the subject of much debate – and market volatility – in the US and it has been well-documented that Donald Trump’s presidency has certainly spurred this on. But as a result of this shake-up, there are now more interesting investment options available.
Elsewhere, we also continue to see potential in the technology sector. This is a fundamental rather than top-down call. For our part, we believe a lot of companies are being misread by the ratings agencies because of their asset-light business models. However, a lot of tech firms have very high margins and very strong cash-flow dynamics, which we think is a far more important and attractive factor, than asset-rich balance sheets.
Looking ahead into 2018, we expect that our continued focus on quality businesses with improving credit metrics will help drive further positive security selection. For now, we are holding our ground and maintaining an overweight to short duration assets, limiting the volatility of the strategy when compared to the overall market. Equally, we’re largely avoiding some industries, such as parts of the retail and telecommunications sectors, which appear to be enduring secular declines.
We’re also focusing on being underweight higher quality, more interest-rate sensitive bond assets, at least, that is, until superior total return opportunities present themselves.
Ultimately, if the two biggest potential market risks are equity volatility spilling over into high-yield and a rising interest rate environment, I believe our short duration strategy is sufficiently insulated and well-positioned to weather any possible storms.