AXA IM’s US Short Duration High Yield Bonds strategy manager, Carl ‘Pepper’ Whitbeck, takes a look at this year’s volatile backdrop and outlines his expectations and strategy for 2018
2018 has certainly been a lot less calm than recent years. Volatility has firmly returned – most notably in equities but also in the fixed income market. In addition, the latest US economic data hasn’t encouraged much cheer, with GDP growth slowing in the first quarter to 2.2% on an annual basis, down from 2.9% in the final three months of 2017.[i]
This however only tells part of the story. The world’s largest economy is still growing at a steady pace and given the disproportionate, adverse impact which weather conditions often have on first quarter data, it could look in better shape when numbers arrive for the April to end of June period.
At its June meeting, as widely expected, the US Federal Reserve raised interest rates by a quarter of a percentage point, taking the central bank’s benchmark to 1.75% – 2% – and further hikes are anticipated.[ii]
Notably, at a press conference, Fed chair Jerome Powell, stated: “The economy is doing very well”.[iii]
US corporate earnings for the first three months of the year have surprised on the upside too, with the majority of S&P 500 companies firmly beating analyst expectations.[iv]
Looking ahead, we expect fiscal stimulus, in the form of tax cuts, to be supportive both this year and next and they should help to extend the current economic cycle.
The inflation conundrum
But naturally, challenges remain. Earlier in the year, the Fed noted that inflation, which has been edging up in recent months, is expected to run near its 2% target and that risks to the economic outlook “appear roughly balanced”.[v]
With the consumer price index running at 2.8% in May – well above its 2% target – one of the main ongoing debates is whether or not the US Federal Reserve is being too aggressive or not aggressive enough, in terms of monetary policy.[vi]
With the unemployment rate now below 4% the question is whether this environment will increase wages and lift inflation?[vii]
Additionally, the extent to which the so-called trade war escalates could potentially also have an impact. If we do see inflation start to pick up further this year, it will present a risk for credit spreads and equity valuations, which could in turn cause some jitters in the high yield sector.
All of this, and more, is fuelling the Fed’s appetite for monetary policy tightening and while a question mark remains about how many times it will ultimately raise rates in 2018, one thing appears certain – interest rates are going up.
But it’s important to bear in mind that if interest rates are rising this is generally because the economy is doing well, which in turn should be good for companies and therefore, for credit in general. Even so, I expect the current trend of market volatility could endure for some time and as a result many investors are not keen to take on a lot of risk right now.
Volatility spurs on new investment opportunities
Given the present backdrop, US short duration high yield strategies could be a good place to hide during this uncertain period. With an average yield-to-worst (i.e. the lowest potential yield that can be received on a security without the issuer actually defaulting) of approximately 4.9% as of May 31, 2018, we believe our US short duration high yield strategy offers a competitive income relative to most other fixed income assets.[viii]
Generally speaking, high yield has historically been better able to weather a rising rate environment because its average duration is lower than most other asset classes in the broader fixed income universe, due to the callable nature of most of the bonds in the market. It is worth noting however that this is by no means guaranteed.
Short duration bonds are also constantly being refinanced and taken out of the market by the companies that issue them – and even if we do nothing, we are typically still getting 4% to 6% per month coming back to us in cash flows, which we can then reinvest at a higher yield in a rising rate environment.
In addition, spreads are typically inversely correlated to interest rates. Therefore when interest rates go up, you often see spread compression, which can offset the negative impact of higher rates.
Evolving investment opportunities
Of course, one benefit of volatility is that it can create opportunity and inject fresh value into the market. And while we continue to identify investments across numerous industries including healthcare and technology, the one area that looks less risky than it did earlier this year, is the oil sector.
US production may be increasing but OPEC has been quite disciplined on its production cuts, more so than it has been in the past. In addition, the US has pulled out of its deal with Iran, while Venezuela has sharply slowed down production. All of these factors have together managed to push something of a risk premium into the oil price. This is something I don’t think is going to go away any time soon and with WTI now at circa $65 a barrel, I believe this is a healthy and profitable level for US producers.
I believe this year will continue to be characterised by higher levels of volatility and market noise. Bond yields are likely to rise – at the end of May, 10-year treasury yields were at around 2.8% and I think reaching around 3.25% by the end of the year is a reasonable assumption.[ix]
But I maintain my conviction that our short duration strategy is well-positioned to deal with both a rising interest rate environment and more volatile market conditions.
I believe the robust underlying economic conditions and good corporate earnings could provide us with a solid mid-single digit return, and that the default rate across the high-yield sector will remain relatively benign too, at approximately 2% or less.
[viii] AXA IM (as at 31 May 2018)
[ix] Bloomberg (as at 31 May 2018)