Corporate Bonds
Highlights China's ongoing industrial sector slowdown will not likely lead to a global growth shock, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Feature We have presented the following views about China's economy and its financial markets over the past several months: China's industrial sector is slowing, and is set to slow further based on our proprietary leading indicators for the Li Keqiang index. This will cause a further deceleration in Chinese nominal import growth and suggests that Chinese ex-tech earnings per share growth will soon peak. Residential investment has potential to provide a tailwind to domestic growth if home sales sustainably pick up, but there are no firm signs that this is occurring. Robust export growth will help China's economy from slowing sharply, but there are several risks to the external demand outlook that need to be monitored. Given the poor growth momentum in the industrial sector, fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. China's consumer-oriented tech sector ostensibly stands out as a shelter from an old economy slowdown, but it is extremely expensive, earnings momentum is very stretched, and it may be adversely impacted by the U.S.' section 301 investigation. We have recommended avoiding exposure since mid-February. China's ex-tech equity market is comparatively cheap, high-beta vs the global benchmark, and technically robust. While the risks to the economic outlook are clear, investors should continue to overweight Chinese ex-tech stocks vs their global peers. For global investors who are perennially concerned that a slowdown in China's economy will culminate in a significant shock to the global economy, Chart 1 provides a helpful visual representation of our view. The chart depicts two scenarios: first, the ongoing industrial sector slowdown in China results in an outright subtraction from global growth momentum via a contraction in imports, despite positive growth impulses from the U.S. and euro area. In our view, Chinese import growth is likely to remain positive, but will largely be driven by strong demand in the developed world (scenario 2). Chart 1Two Different Scenarios Concerning China's Contribution To The Global Economy Chart 1 highlights that our view is more positive for the global economy than one might otherwise think, but it is important for investors to understand the nature of China's relative stability in the event that export growth surprises to the downside over the coming months. In fact, Chart 2 highlights that the most salient data development over the past two weeks has been a fairly significant deceleration in smoothed nominal export growth, which is our preferred method of analyzing Chinese trade data. Despite the relative stability of China's PMIs over the past few months, a 3-month moving average of US$ exports decelerated from 17.5% to 7% in May, or from 10% to -1% in RMB-terms. Sequentially, Chinese export growth improved in May (vs April's reading) in both US$ and RMB-terms, and both beat market expectations. As a result, we are sticking with the second scenario depicted in Chart 1 as the more likely of the two for the coming 6-12 months. However, the reliance on strong external demand to prop up China's import growth is somewhat of a "shaky ladder" for global investors to climb, given the clear risks from U.S. protectionist action, the headwinds to Chinese export competitiveness from a strong currency (or, alternatively, the punishing impact of translation effects on exporter revenue), and the potential for robust export growth to embolden Chinese policymakers to push forward with even more aggressive reforms over the coming year. Still, Chart 3 highlights that many investors are perfectly willing to climb this ladder, shaky or otherwise. The chart shows that the relative performance of Chinese ex-tech stocks versus their global peers remains firmly within the ascending trend channel that has been in place since early-2017, despite the ongoing slowdown in the industrial sector. As we noted in our May 30 report,1 this message is consistent with the view that any recent negative relative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. Chart 2A Nontrivial Slowdown In Chinese Export Growth Chart 3Investors Are Fine Climbing A Shaky Ladder We remain nervous bulls concerning Chinese ex-tech stocks, and continue to recommend an overweight stance. But our reading of China's macro dynamics suggests that investors should not be dogmatic about their equity allocation to China, and should be prepared to cut exposure in response to a material shift in sentiment towards the Chinese economy. As a final point, while we have clearly presented our framework over the past several months for thinking about and analyzing China, investors attending BCA's Annual Investment Conference in September will get an opportunity to hear additional perspectives about the cyclical trajectory of its economy. Leland R. Miller, CEO of the China Beige Book, will be presenting his thoughts on the outlook for Chinese growth and risk assets. Based on his firm's unique insights into China's economic and financial market developments, Mr. Miller's panel will certainly be among those not to miss. Bottom Line: China's ongoing industrial sector slowdown will not likely lead to a shock to global demand, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. A-Shares: EM Inclusion, Factor Analysis, And A Contrarian Shadow Trade The beginning of June marked a milestone for Chinese equities, as MSCI added over 226 large-cap A-shares to their Emerging Markets index. Box 1 provides some brief details about the inclusion, and also notes how it affects several of the trades in our trade book. Chart A1A-Share Inclusion Added 10% Market Cap ##br##To The MSCI China Index Box 1 The Inclusion Of Chinese A-Shares In The MSCI Emerging Markets Index On May 31 2018, 226 China large-cap RMB-denominated A-shares were included in the MSCI Emerging Markets Index. The change represented a 1.4% increase in the market capitalization of the MSCI Emerging Markets index, and 10% increase in the MSCI China Index (Chart A1). We have often referred to the MSCI China Index as the "investable" index in previous reports and in our trade table, but this index now includes some domestic stocks as a result of the recent inclusion. We plan to continue to use the MSCI China Index (or its ex-tech equivalent) as the main outlet for our investment recommendations, which means that the benchmark for five of our trades will be re-labeled in our trade table (from China investable to MSCI China Index). One exception is our trade favoring the MSCI China ESG Leaders Index, as MSCI has yet to publish an ESG rating index for Chinese domestic stocks. We last wrote about the outlook for A-shares in our March 14 Weekly Report,2 and noted that the significant underperformance of A-shares relative to global stocks over the past few years was due to the legacy effects of an enormous, policy-driven speculative bubble in 2014-2015. We highlighted that while domestic stocks have worked off some of this bubble and multiples are no longer extreme, that a neutral allocation was still warranted due to an uninspiring earnings outlook and, at best, a very modest valuation discount relative to global stocks. Chart 4 illustrates this latter point; based on all four trailing valuation ratios that we track, ex-tech onshore stocks are either on par or considerably more expensive than global ex-tech stocks. By contrast, the MSCI China Index (excluding technology) is cheaper than their global peers by all measures, in some cases considerably so. Nevertheless, while we continue to recommend that investors maintain a neutral stance towards A-shares within a global equity portfolio, the inclusion of A-shares in the EM index may force some investors to increase their exposure to domestic stocks beyond the level that they otherwise would have maintained. In order to provide some perspective of what domestic stocks to favor, we have taken a quantitative approach to analyzing A-shares that is loosely inspired by the Fama-French three-factor model. More precisely, we have examined the historical relative performance of three separate factor strategies for A-shares and global stocks, both relative to their respective broad market. The three factors tested are as follows: Return On Equity (ROE): Replacing market beta in the F&F model, we have built a historical portfolio for both Chinese domestic and global stocks that favors level 1 GICS sectors with above-median ROE. Within high-ROE sectors, the portfolio allocates to the sectors on a value-weighted basis to maximize the investability of the strategy. Sector Weight: Our second approach favors GICS sectors with a below-median sector weight, which conceptually mimics the firm size factor in the F&F model. In reality, this strategy is selecting among sectors made up of large cap firms, meaning that investors should regard the performance of this strategy as reflecting the success or failure of investing in potentially underowned or unloved sectors. Value: Our third factor is exactly in line with the F&F model, with portfolios using this approach favoring sectors with above-median dividend yields. We have chosen a cash flow-based valuation measure instead of the book value yield to assuage potential investor concerns about accrual quality. Chart 5 presents the cumulative returns of these strategies, for both global and Chinese domestic stocks. Several important observations are noteworthy: Chart 4A-Shares Are Not Cheap Vs##br## Global Stocks In Ex-Tech Terms Chart 5ROE, Sector Weight, and Value Are ##br##All Successful Factors In China's Domestic Market Favoring high-ROE sectors has been a more profitable strategy when allocating among global sectors than those of the domestic Chinese market, but we have seen similar returns from the strategy in both markets since early-2011. This is consistent with an important conclusion that we made in our March report: the perception among some global investors that domestic Chinese stocks are a "casino" market disconnected from fundamentals does not appear to be supported by the data over the past several years. A strategy of favoring sectors with a low market cap weight has fared better for Chinese A-shares than for the global market, albeit with considerable volatility. We suspect that the underperformance of smaller-than-average sectors at the global level has been affected over the past four years by the underperformance of resources, but the outperformance of the strategy in China also makes sense: underowned or unloved sectors should have more abnormal return potential in smaller, less scrutinized markets. Favoring cheap stocks has been an abysmally poor strategy at the global level over the past decade, due to the chronic underperformance of the financial sector. But cheaper sectors have outperformed China's domestic equity market at a modest pace over the past several years, which is good news for value-oriented investors. Chart 6 highlights where each of China's domestic equity sectors currently sits in the ROE/size/value spectrum. There are three sectors exhibiting two of the factors employed in our analysis: health care, financials, and real estate. For now, we would caution investors against buying domestic health care stocks, as Chart 7 shows that the sector has become heavily overbought over the past several months. Domestic financials would appear to be a better bet: despite underperforming financials in the MSCI China Index, domestic financials have outperformed the domestic broad market over the past year and have not broken materially below their trend line despite a recent selloff. Chart 6Health Care, Financials, And Real Estate Are At The Intersection Of Successful Factors Chart 7Financials Are A Better Bet Than Health Care; Watch For A Housing Catalyst To Buy Real Estate Finally, real estate stocks have the potential to become a fantastic contrarian trade if Chinese home sales do sustainably pick up. The sector is cheap, profitable, and highly unloved given the view among many investors that the Chinese government's structural reforms will weigh on performance for some time to come. But as we have noted in previous reports, the persistent gap between home sales and housing construction over the past few years may very well be over, implying that the latter may rise in lockstep with the former if sales begin to trend higher. Chart 7 shows that investors are not even remotely pricing in such a scenario, as domestic real estate companies have underperformed the domestic benchmark since early-2016 and remain in a relative downtrend. We would not recommend fighting negative investor sentiment towards the sector for now, but domestic real estate companies should clearly be on an investor's watch list, alongside the trend in residential sales volume. Bottom Line: The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. An Update On China's Corporate Bond Market China's equity market may not be the only financial market segment to garner more addition from increased index inclusion over the coming year: Bloomberg recently announced that it will add Chinese RMB-denominated government and policy bank bonds to the Bloomberg Barclays Global Aggregate Index over a 20-month period beginning in April 2019, conditional on the implementation of certain "operational enhancements" to the market by the PBOC and Ministry of Finance.3 China's total bond market (government and corporate) is the third-largest in the world, with a record of 79 trillion yuan ($12.7 trillion) outstanding. Yet foreign investors have little exposure to Chinese bonds, due to frictions concerning investability, a lack of transparency on issuers/index components, and concerns about the quality of domestically-issued credit ratings (95% of China's corporate bonds are rated AA- or higher). Chart 8The Recent Uptick In Yields Has Had A Paltry Impact On Total Returns While the proportion of foreign ownership of Chinese bonds may rise slowly over time, our sense is that it will indeed rise. First, there is a clear yield advantage for Chinese relative to global bonds, in a world where high long-term absolute return prospects are scarce. Second, Chinese policymakers continue to (slowly) open China's financial markets to the rest of the world, and global investors can now gain access to China's onshore bond market through four channels without quota: the qualified foreign institutional investors program (QFII), the renminbi qualified foreign institutional investor program (RQFII), the China interbank bond market (CIBM), and the Bond Connect program.4 Third, China's regulators allowed foreign-owned ratings agencies to set up shop in China last year, in an attempt to address the ratings quality issue. BCA's China Investment Strategy service initiated our long China onshore corporate bonds trade on June 22 last year, which has since earned a 3.7% return in spite of widening yield spreads and a spike in default concerns over the past several weeks. Indeed, Chart 8 highlights that the recent rise in corporate yields has had a minimal impact on the index total return profile. There is one critical factor driving this apparent discrepancy that is not well understood by global investors: compared with corporate issues in the developed world, China's corporate bond market has considerably shorter duration. Table 1 highlights that most of the corporate bonds issued in China have a maturity of three years or less, and the duration for the ChinaBond Company Credit Index, the benchmark that we have used for our corporate bond trade, is approximately 2.3 years. By contrast, U.S. investment- and speculative-grade bonds currently have an effective duration of 7.5 and 4 years, respectively. Chart 9 illustrates the 12-month breakeven spread for the Company Credit Index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. The chart shows that Chinese corporate bond yields would have to rise approximately 250 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that is totally inconsistent the PBOC's monetary policy stance. Table 1Maturity Distribution Of China's Bond Market Chart 9A Compelling Cushion Against Potentially Higher Rates Another way to gauge the attractiveness of a corporate bond position is to look at the spread relative to comparable duration government bonds in order to calculate the default loss that would be required to erase the spread (which is also roughly 250 bps today). Using the relatively conservative assumption of a 35% recovery rate, a 2.5% default loss implies a default rate of close to 4%. We noted in our May 23 Special Report that recent corporate defaults in China amounted to only 0.1% of the outstanding corporate bond market,5 implying that the ultimate scope of corporate bond defaults in China would have to be 40 times larger than currently observed to wipe out the spread relative to Chinese government bonds of comparable duration. While we cannot rule such an event from occurring, there is no evidence to suggest that such a dramatic escalation in defaults is about to occur. Bottom Line: Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "A-Shares: Stay Neutral, For Now", dated March 14, 2018, available at cis.bcaresearch.com. 3 These enhancements include the implementation of delivery vs. payment settlement, the ability to allocate block trades across portfolios, and clarification on tax collection policies. 4 The first three programs have a clear statement that no quotas apply, whereas the bond connect program has no specific statement concerning quotas. 5 Pease see China Investment Strategy Special Report "Messages From BCA's China Industry Watch", dated May 23, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Fed: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. Credit Cycle: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Emerging Market Debt: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Feature The Federal Reserve meets this week and will deliver the second rate hike of the year, bringing the target range for the federal funds rate up to 1.75% - 2%. With that hike already fully discounted, investors will be more concerned with parsing the post-meeting statement, Summary of Economic Projections, and Chairman Powell's press conference for clues about the future path of rates. We expect only minor changes to the statement, though the Committee could decide to tweak its promise that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run". Such a change would simply acknowledge that if gradual rate hikes continue, then the federal funds will move close to most estimates of its neutral (or equilibrium) level within the next 12 months. This touches on an important question for bond investors. Would the Fed actually start to slow the pace of rate hikes once the funds rate reaches its estimated neutral level? Or will it need to see some evidence of decelerating economic growth before slowing the pace of rate hikes below its current 25 bps per quarter pace? Chart 1 shows why this question is important. The shaded boxes in that chart outline a "gradual" rate hike path of 25 bps per quarter. The Fed has been lifting rates at this pace since late 2016. The "x" markings denote the median expected fed funds rate from the Fed's Survey of Primary Dealers, and the "F" markings denote the Fed's own median projections. Notice that there are two "F"s shown at the end of 2018. This is because an equal number of FOMC participants (6) expect a fed funds rate of 2% - 2.25% as expect one of 2.25% - 2.5%. We expect the median will coalesce around the 2.25% to 2.5% range by the end of tomorrow's meeting. Chart 1The Outlook For Rate Hikes Notice in Chart 1 that both primary dealers and the Fed expect to deviate from the quarterly rate hike pace around the middle of next year. This would be consistent with the pace of hikes starting to slow as the fed funds rate approaches its currently anticipated neutral level near 3%. But how confident is the Fed in its estimate of that neutral rate? We would argue that its confidence should be quite low. We are not alone in this assessment. In one of Janet Yellen's final speeches as Fed Chair she warned against placing too much confidence in estimates of the neutral rate.1 [T]he neutral rate changes over time as a result of the interaction of many forces, including demographics, productivity growth, fiscal policy, and the strength of global demand, so its value at any point in time cannot be estimated or projected with much precision. We expect that the current FOMC will heed this warning, and if there are no signs of economic deterioration by the middle of next year, then the Fed will continue to hike rates at a pace of 25 bps per quarter and estimates of the neutral rate will be revised higher. We examined what could potentially make the Fed deviate from its 25 bps per quarter rate hike pace, by hiking either more quickly or more slowly, in a recent report.2 Crucially, Chart 1 shows that not only is the market priced for the Fed to slow its pace of rate hikes as we reach the middle of next year, it is also priced for a slower pace of rate hikes than is expected by the Fed or the primary dealers. This divergence means that below-benchmark portfolio duration continues to make sense on a 6-12 month horizon. Bottom Line: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. A Quick Update On Our Tactical Long Position On May 22 we advised clients with a short-term (0-3 month) horizon to position for lower U.S. bond yields in the near term.3 This call was premised on two catalysts. First, bond market positioning had become excessively net short. That picture now looks more mixed (Chart 2). Net speculative positions in 10-year Treasury futures remain deep in "net short" territory and the Marketvane survey of bond sentiment is still "bearish", but the JP Morgan Duration Surveys for both "all clients" and active clients" have moved somewhat closer to neutral. The second catalyst was that our auto-regressive model pointed to strong odds of a negative reading from the U.S. Economic Surprise Index during the next month (Chart 3). This remains the case, but the reading from our model has moved much closer to the zero line. Chart 2Positioning Now Closer To Neutral Chart 3Surprise Index Still Low Taken together, our two indicators no longer send a resounding "buy bonds" signal. But given the deeply net short Treasury futures positioning and the low level of the surprise index, we are inclined to maintain our tactical buy recommendation for another week. We will re-assess again next week based on trends in the surprise index and the positioning data. The Fed & The Credit Cycle The Powell Fed has so far not been kind to credit spreads. Since February our index of financial conditions has tightened considerably, driven by a combination of falling equity prices, wider quality spreads and a stronger dollar (Chart 4). Yet, the Fed seems relatively unconcerned and is broadly expected to lift rates this week. All in all, the Powell Fed seems less concerned with responding to tighter financial conditions than was the Yellen Fed. Chart 4How Much Pain Can The Fed Take? There is some truth to this observation, though we think the difference has more to do with recent trends in inflation than with any change in approach between the two Fed Chairs. As inflation pressures mount, the Fed is marginally less concerned with responding to weakness in financial markets and marginally more concerned with preventing an inflation overshoot. This is why we will reduce our allocation to corporate bonds once our monetary indicators tell us that inflation expectations are well anchored around the Fed's target. Monetary Indicators Long maturity TIPS breakeven inflation rates are the primary indicators we are monitoring in this regard. When both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%, that will be consistent with past periods of well-anchored inflation expectations and we will start reducing exposure to corporate credit (Chart 5). But we should not rely solely on one indicator. It is conceivable that the financial crisis ushered in a structural shift (possibly due to stricter banking regulations) and that the level of TIPS breakevens consistent with well-anchored inflation expectations is now slightly lower.4 For this reason we also pay attention to the St. Louis Fed's Price Pressures Measure (Chart 5, bottom panel). This model is designed to output the percent chance that inflation will exceed 2.5% during the next 12 months, and we have found that corporate bond excess returns decline significantly when it exceeds 15%.5 It currently sits at 13%. Finally, it's also a good idea to pay attention to core PCE inflation itself. The year-over-year rate of change in core PCE inflation jumped sharply in recent months, but it has not yet returned to the Fed's 2% target (Chart 6). It is therefore still reasonable to expect that inflation expectations are not consistent with target inflation. It is likely that many investors still have doubts about whether inflation will recover to the Fed's target. Chart 5Credit Cycle: Monetary Indicators Chart 6The Fed's Inflation Model Those doubts would probably fade if the year-over-year rate of change in core PCE inflation actually rose to 2% and stayed there for several months. At that point we would have to conclude that inflation expectations are well anchored, whatever the level of TIPS breakeven rates. Incidentally, the recent bounce in core inflation brought it back in line with the reading from Janet Yellen's Phillips Curve model that she presented in a speech from 2015.6 In the context of this model, a continued decline in the unemployment rate will pressure inflation slowly higher, meaning that we expect to receive a signal from our monetary indicators sometime this year. We will pare exposure to corporate bonds at that time. It will be very interesting to hear from Chair Yellen herself when she visits the BCA Conference in September, and we hope to gain insight not only about her inflation forecast but also about how the Fed thinks about its responsiveness to financial markets, and most importantly, about how the Fed is likely to manage the tightening cycle as the funds rate approaches its estimate of neutral. Credit Quality Indicators Outside of Fed policy and the inflation outlook, we are also closely monitoring the relationship between profit growth and debt growth for the nonfinancial corporate sector. Leverage rises whenever debt growth exceeds profit growth and rising leverage tends to coincide with widening credit spreads (Chart 7). Nonfinancial corporate debt grew at an annualized rate of 4.4% in the first quarter, while pre-tax profits actually contracted at an annualized rate of 5.7%. As a result, our measure of gross leverage ticked higher from 6.9 to 7.1. More broadly, profits grew 5.8% in the four quarters ending in Q1 2018, only slightly faster than the 5.2% increase in corporate debt. This does not provide much of a buffer, and it will not take much to send profit growth below debt growth on a sustained basis. In fact, we expect that if labor compensation costs continue to accelerate we will see leverage start to rise more meaningfully in the second half of this year. Our overall Corporate Health Monitor improved noticeably in the first quarter (Chart 8). But this large move will almost certainly reverse in Q2. The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart 8, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (Chart 8, bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. Chart 7Leverage Is Poised To Head Higher Chart 8Tax Cuts Helped Balance Sheets In Q1 Bottom Line: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Still No Opportunity In Emerging Market Debt We pointed out in a recent report that a persistent divergence between U.S. and non-U.S. economic growth was the most likely catalyst that could cause the Fed to slow its pace of rate hikes.7 A divergence between strong U.S. growth and weaker growth in the rest of the world puts upward pressure on the U.S. dollar, and this is a particular problem for many emerging markets that carry large balances of U.S. dollar denominated debt. Our Emerging Markets Strategy service published a Special Report last week that explains in detail this particular problem faced by emerging markets and shows which countries face the most pressing debt concerns.8 For U.S. fixed income investors another important question is whether the recent strength in the U.S. dollar, and weakness in emerging market currencies, has resulted in an opportunity to shift out of U.S. corporate credit and into USD-denominated emerging market sovereign debt. On that note, Chart 9 shows that the average option-adjusted spread for the Baa-rated U.S. Corporate bond index recently dipped below the average spread for the investment grade USD Emerging Market (EM) Sovereign index. However, we think it is still too soon to move into emerging market debt. After adjusting for differences in duration and spread volatility between the two indexes, we come up with a measure of "Months-To-Breakeven". This indicator shows the number of months of spread widening required for each index to lose money relative to U.S. Treasuries. By this measure, U.S. Corporate bonds still look attractive compared to investment grade EM Sovereigns. At the country level, Chart 10 shows the 12-month breakeven spread for the USD-denominated sovereign debt of several major EM countries. It also shows each country's foreign funding requirement, a measure of the foreign capital inflows required in the next 12 months for each country to cover any shortfall in current account transactions and service its foreign currency debt. Chart 9EM Sovereigns Are Still Expensive Chart 10USD-Denominated Emerging Market Debt: Risk/Reward At The Country Level For the Baa-rated countries, Colombia, Mexico and Indonesia all offer spreads similar to what can be found in the Baa-rated U.S. Corporate bond market. The Philippines looks quite expensive, but Russia looks cheap compared to U.S. Corporates and has one of the lowest foreign funding requirements of any EM country. In High-Yield space, Turkey is fairly priced relative to Ba-rated U.S. junk, while Brazil and South Africa both look expensive. Argentina also looks expensive relative to B-rated U.S. junk. Bottom Line: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 We explored some possible reasons for such a shift in the U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 7 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Special Report, "A Primer On EM External Debt", dated June 7, 2018, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart 1Risks To The Bond Bear Market Two weeks ago we flagged that large net short positioning and elevated growth expectations left the Treasury market primed to benefit from any disturbance in the economic outlook. Since then the 10-year yield fell from a peak of 3.06% to 2.77%, before climbing back to 2.92%. With positioning still deeply net short and strong odds of a further decline in the economic surprise index (Chart 1), we continue to see an elevated risk that yields move lower on a 0-3 month horizon. But beyond that, less nimble investors should remain positioned for higher yields on a 6-12 month timeframe. The major risks in the global economy - Eurozone sovereign credit concerns and a strong dollar weighing on emerging market demand - are unlikely to put the Fed off its "gradual" pace of one rate hike per quarter unless they lead to a significant risk-off event in U.S. financial markets. Absent that sort of shock, the Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory. This rate hike path is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to -122 bps. Value has improved considerably since the start of the year. The 12-month breakeven spread for a Baa-rated corporate bond is back up to its 29th percentile relative to history (Chart 2). Market-derived inflation expectations also ebbed during the past month, with the 10-year and 5-year/5-year forward TIPS breakeven inflation rates now at 2.09% and 2.12% respectively. This is below the target range of 2.3% to 2.5% that would trigger a downgrade to our corporate bond allocation. The combination of more attractive value and a somewhat more supportive monetary environment (as evidenced by the decline in TIPS breakeven rates) increases the odds of near-term corporate bond outperformance, and we would not be surprised to see spreads tighten during the next few months. However, the longer run outlook for corporates remains negative. First quarter data showed a 5.7% annualized decline in pre-tax corporate profits, dragging the year-over-year growth rate down to 5.8% (bottom panel). As employee compensation costs accelerate in the second half of the year, we expect that corporate profit growth will fall sustainably below the pace of corporate debt growth leading to rising leverage (panel 4). Strong oil prices have caused the energy sector to outperform the overall index considerably since the middle of last year. Now, many energy sub-sectors no longer appear cheap on our model. We take this opportunity to downgrade a few energy sub-sectors from overweight to neutral, and adjust some other sector recommendations as well (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +36 bps. The average index option-adjusted spread widened 24 bps on the month, and currently sits at 356 bps. High-yield spreads are increasingly at odds with Moody's default rate projections. The latter call for the 12-month speculative grade default rate to fall to 1.5% by next April. The current 12-month trailing default rate is 3.7% (Chart 3). Using the Moody's default rate projection, and our own forecast for the recovery rate, we calculate the excess spread available in the Bloomberg Barclays High-Yield index to be 284 bps (after accounting for expected default losses). This is somewhat higher than the historical average of 248 bps. The current excess spread means that in an unchanged spread environment we would expect a High-Yield excess return (relative to duration-matched Treasuries) of +278 bps during the next 12 months. If the index spread were to tighten by 100 bps, we would expect an excess return of +675 bps. If the index spread were to widen by 100 bps we would expect an excess return of -120 bps (panel 3). If the excess spread were to simply revert to its historical average, then it would imply an excess High-Yield return of +427 bps. At the sector level, Moody's expects that most defaults during the next 12 months will come from the Media: Advertising, Printing & Publishing sector, followed closely by the Durable Consumer Goods and Retail sectors. Much of the projected improvement in the overall default rate results from a continued decline in Oil & Gas sector defaults compared to the past few years. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in May, dragging year-to-date excess returns down to -27 bps. The conventional 30-year zero-volatility MBS spread widened 4 bps on the month, driven entirely by a 4 bps increase in the compensation for prepayment risk (option cost). The option-adjusted spread held flat at 32 bps. Value in the MBS sector is by no means exciting. The nominal spread on a conventional 30-year MBS is near its all-time low, the option-adjusted spread is close to one standard deviation below its pre-crisis mean (Chart 4) and MBS no longer look very attractive compared to investment grade corporate credit (panel 3). The most compelling reason to hold agency-backed MBS is that mortgage refinancings are likely to remain very low, owing both to rising interest rates and the large number of homeowners that have already refinanced. Depressed refi activity should keep MBS spreads near historically low levels (bottom panel), even as stresses emerge in other spread product sectors, notably corporate bonds. We recently presented a method for calculating expected total returns for all different bond sectors, only using assumptions for the number of Fed rate hikes during the next 12 months and the expected change in spreads.1 Our results showed an expected total return of 2.9% for conventional 30-year MBS in a scenario where the Fed lifts rates by 100 bps and where spreads remain flat. The same scenario corresponds to 3.4% total return for the investment grade corporate index. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in May, dragging year-to-date excess returns down to -40 bps. Sovereign debt underperformed the Treasury benchmark by 158 bps on the month, dragging year-to-date excess returns down to -242 bps. Foreign Agencies underperformed by 37 bps on the month, dragging year-to-date excess returns down to -56 bps. Local Authorities underperformed by 22 bps on the month, dragging year-to-date excess returns down to +37 bps. Supranationals underperformed by 2 bps on the month, dragging year-to-date excess returns down to +2 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to +7 bps. Global growth divergences and a stronger U.S. dollar weighed on Sovereign bond returns in May (Chart 5). While value in the sector improved somewhat as a result, it remains expensive relative to investment grade corporate credit (panel 2). With dollar strength likely to persist in the near-term, we remain underweight Sovereign bonds. Conversely, we reiterate our overweight recommendations on Foreign Agency and Local Authority bonds. Those sectors still offer compelling valuations and are less sensitive to a strong U.S. dollar than the lower-rated Sovereign sector. Supranationals and Domestic Agency bonds are low risk but do not offer sufficient spread to warrant much attention. Better low-risk spread product opportunities are available in the Agency CMBS and Consumer ABS sectors. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +110 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% on the month and, at 86%, it is very close to its post-crisis low (Chart 6). It remains somewhat elevated compared to the average level of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Technically, yield ratios have been supported by robust fund flows and subdued issuance (panels 2 & 3), while fundamentally our Municipal Health Monitor suggests that ratings upgrades will continue to outpace downgrades for the time being (not shown). The message from our Health Monitor is confirmed by the trend in state & local government net borrowing (bottom panel). First quarter data, released last week, showed a sizeable drop in net borrowing as state & local governments managed to grow revenues by $46 billion while growing expenditures by only $25 billion. This is consistent with governments working hard to repair their budgets, raising taxes and slowing spending growth, as we showed in a recent report.2 Given tight municipal valuations, we continue to see better opportunities in the corporate bond space than in municipal bonds. But we will look to upgrade munis at the expense of corporates as we approach the end of the credit cycle. Hopefully, from a more attractive entry point. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in May. The 2/10 Treasury slope flattened 3 bps to end the month at 43 bps. The 5/30 slope held steady at 32 bps. The short-end of the Treasury curve is still not adequately priced for the Fed's likely pace of one 25 basis point rate hike per quarter. Such a pace translates to a level of 100 bps on our 12-month discounter, which currently sits at only 73 bps (Chart 7). Similarly, the long-end of the Treasury curve is not adequately priced for the likely trend in inflation. The 10-year TIPS breakeven inflation rate is at only 2.09%, below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. We anticipate that higher TIPS breakevens at the long end of the curve will be roughly offset by loftier rate expectations at the short end of the curve, leaving the slope of the Treasury curve close to current levels during the next few months. In a recent report we introduced a framework for identifying the most attractively valued butterfly trades across the entire yield curve.3 The results, shown in Table 4, identify the 7-year bullet over the 1-year/20-year barbell as the most attractively valued butterfly trade that is geared toward curve steepening. According to our model, that trade is priced for 56 bps of 1/20 flattening during the next six months (panel 4). That seems excessive given the low level of long-maturity TIPS breakevens. Table 4Butterfly Strategy Valuation (As Of June 4, 2018) TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +95 bps. The 10-year TIPS breakeven inflation rate fell 10 bps on the month and currently sits at 2.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 13 bps and currently sits at 2.12%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.4 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. Recent trends show that inflation is steadily making progress toward the Fed's 2% goal. The 12-month rate of change in the core PCE deflator is back up to 1.8%, from 1.5% in February. However, the core PCE deflator has only increased by 0.15% in each of the past two months. Consistent monthly prints above 0.165% are required to reach the Fed's 2% target (Chart 8). We expect tight labor markets and strong pipeline pressures (panel 3) to drive inflation higher in the months ahead. Although, as we discussed last week, the risk of a significant overshoot of the Fed's inflation target during the next 6-12 months is low.5 ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -3 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp on the month and now stands at 41 bps, 7 bps above its pre-crisis low. While consumer ABS offer reasonably attractive expected returns relative to other low-risk spread product (Agency CMBS, Domestic Agency bonds and Supranationals), credit risk is slowly starting to build in the sector. The New York Fed's Household Debt and Credit report showed that the 90+ day credit card delinquency rate rose above 8% in Q1 for the first time since 2015. Meanwhile, the overall consumer credit delinquency rate continues to increase alongside a rising debt service ratio (Chart 9). On the supply side, banks reported tightening credit card lending standards for the fourth consecutive quarter in Q1, while auto loan lending standards were tightened for the eighth consecutive quarter. Periods of tightening lending standards tend to coincide with rising delinquencies and wider spreads (bottom panel). In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect Aaa-rated credit card ABS to return 2.3% and Aaa-rated auto loan ABS to return 2.4%.6 Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month and currently sits at 70 bps, close to one standard deviation below its pre-crisis mean. Banks eased lending standard on nonfarm nonresidential loans in Q1 for the first time since 2015, and continued easing could signal lower delinquencies in the future (Chart 10). Easier lending standards could also support commercial real estate prices, which have decelerated recently and currently pose a risk for spreads (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +13 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 48 bps. In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect non-agency Aaa-rated CMBS to return 2.8% and Agency CMBS to return 2.6%.7 Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.54%. The drop in the model's fair value compared to last month stems from a decline in the global PMI from 53.5 to 53.1, and a rise in dollar bullish sentiment from 60% to 67%. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. As resource slack dissipates, inflationary pressures mount and the same pace of global growth should be associated with a higher Treasury yield. This means that as we approach the end of the cycle, the 2-factor model will start producing fair value readings that are consistently too low. We can attempt to correct for this by incorporating a measure of resource slack into our model, in this case the employment-to-population ratio. A model for the 10-year Treasury yield based on the employment-to-population ratio and the Global PMI produces a fair value of 3.29% (Chart 11). As we move further toward the end of the cycle, and away from the zero-lower bound on the fed funds rate, we expect the regression coefficients shown in the bottom three panels will revert to their pre-crisis levels and Treasury fair value will revert closer to the one shown in the second panel. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights 0 To 3 Months: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. 6 to 12 Months: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. Total Return Forecasts: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Feature Chart 1Two Milestones The U.S. bond market reached one noteworthy milestone last week and is quickly closing in on another. The first milestone is that the 10-year Treasury yield decisively broke through the 3% level that had defined its most recent peak (Chart 1). The second milestone is that the market is now close to fully pricing-in the likely near-term path for Fed rate hikes. We noted in a recent report that the Fed's "gradual" rate hike path is quite clearly defined as one 25 basis point rate hike per quarter.1 This equates to 100 bps on our 12-month Fed Funds Discounter, which currently sits at 91 bps, just below this key level (Chart 1, bottom panel). We continue to see upside in Treasury yields on a cyclical horizon. Though tactically, the likelihood of a near-term pullback in yields has increased greatly during the past few days. In this week's report we outline the case for a near-term (0-3 month) pullback in Treasury yields, but also look ahead by introducing a simple framework investors can use to make total return forecasts for all different U.S. bond sectors. The Case For A Near-Term Pullback In addition to the fact that the market is closer to fully discounting the likely near-term path of rate hikes than it has been for some time, there are two other reasons to expect a near-term, temporary pullback in yields. The first is that the below-benchmark duration trade has become the consensus position in the market (Chart 2). Net speculative short positions in 10-year Treasury futures have rarely been greater, and since the financial crisis large net short positions have correlated quite strongly with a decline in the 10-year yield during the subsequent three months. Similarly, positions reported in the JP Morgan Duration Survey are firmly in "net short" territory for both the "all clients" and "active clients" surveys. The Marketvane survey of bond sentiment has also turned bearish for only the fourth time since 2010. Each of the other three times has coincided with a near-term drop in yields. Chart 2Bond Market Looks Oversold But positioning alone would not be enough to convince us that yields might decline in the near-term. Investors also need a catalyst. An excuse to take profits on large net short positions that have been working well. That catalyst is typically a period of worse-than-expected economic data. To judge the trend in economic data relative to expectations we turn to the Economic Surprise Index. Chart 3Economic Surprise Index In a report from last year we demonstrated that if the Economic Surprise Index ends a month below (above) the zero line, it is very likely that Treasury yields fell (rose) during that month.2 Also, we know that the surprise index is mean reverting by its very nature. A long period of positive (negative) data surprises will certainly be followed an upward (downward) revision to investors' economic expectations. Eventually expectations become so elevated (depressed) that they become impossible to surpass (disappoint). The index will then start to mean revert. In that same report from last year we also introduced a simple auto-regressive model of the surprise index, designed to capture its average speed of mean reversion. Based on that model, which is purely a function of the index's own lags, we would expect the surprise index to dip slightly into negative territory in one month's time (Chart 3). Though given the large amount of uncertainty in the model, a fairer assessment would be that it is no longer a given that the surprise index will remain above the zero line in the near-term. Bottom Line: Extended net short positioning and the recent moderation in economic data suggest that Treasury yields are ripe for a near-term pullback. Investors who are able should consider tactically buying bonds on a 0-3 month horizon, but with a tight stop loss. Less nimble investors are better off riding out any potential near-term volatility and maintaining below-benchmark portfolio duration on a 6-12 month horizon. The Cyclical Picture Is Unchanged On a 6-12 month investment horizon, we are sticking with the playbook of our Two-Stage Bond Bear Market.3 The first stage is characterized by the re-anchoring of inflation expectations, and here, long-maturity TIPS breakeven inflation rates are still slightly below our target range of 2.3% to 2.5% (Chart 4). We also think bond investors should maintain an overweight allocation to spread product, though the time to trim exposure is approaching. Because the Fed's support for credit markets will weaken as inflation pressures mount, we will start reducing exposure to spread product once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are within our target 2.3% to 2.5% band. The intuition that the credit cycle is long in the tooth is further supported by the fact that the 2/10 Treasury curve is close to 50 bps (Chart 4, bottom panel). In a recent report we showed that while corporate bond excess returns relative to Treasuries usually remain positive until the yield curve inverts, they decline dramatically once the slope dips below 50 bps.4 Valuation also remains tight in the corporate bond market. While investment grade corporate bond spreads have widened in recent months, the junk spread is still close to its post-crisis low, as is the differential between the junk and investment grade spread (Chart 5). Chart 4Inflation Compensation Chart 5Flirting With The Lows The recent widening of investment grade corporate spreads appears to simply reflect a reversion to more reasonable valuation levels, after they had been extremely expensive at the start of the year. Chart 6 shows the 12-month breakeven spread for each investment grade credit tier. We look at the breakeven spread - defined as the spread widening required to lose money versus Treasuries on a 12-month horizon - in order to adjust for the changing duration of the index over time. Chart 6 also shows the breakeven spread as a percentile rank relative to history. In other words, it shows the percentage of time that the breakeven spread has been lower in the past. Notice that earlier in the year investment grade corporate spreads had been approaching all-time expensive levels. They are now closer to the 25th percentile, much more in line with similar spreads for the High-Yield credit tiers (Chart 7). Chart 6Investment Grade Breakeven Spreads Chart 7High-Yield Breakeven Spreads There is no longer a risk-adjusted opportunity in high-yield corporate bonds relative to investment grade. Bottom Line: We recommend that investors maintain below-benchmark portfolio duration on a 6-12 month horizon, consistent with our Two Stage Bond Bear Market framework. While the credit cycle is in its late stages, it is still too soon to reduce exposure to corporate bonds. We will pare exposure to corporate bonds once our TIPS breakeven inflation targets are met. A Simple Framework For Forecasting Total Returns In a recent report we observed that, using a 12-month investment horizon, the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.5 With that in mind, this week we extend that analysis to develop a simple framework for forecasting bond total returns. The framework relies on the fact that the "12-month rate hike surprise" described above is correlated with the 12-month change in Treasury yields. The Appendix to this report shows the historical correlation between the 12-month rate hike surprise and the 12-month change in several different par-coupon Treasury yields. Unsurprisingly, the correlation is very strong for short maturity yields, and gradually weakens as we move further out the curve. This is important because it means that the total return forecasts we generate from this exercise will be more accurate for bond sectors with low duration than for those with high duration. Table 1 shows the total return forecasts we generated for the Bloomberg Barclays Treasury Master Index and for several of its maturity buckets. The results are presented in such a way that readers can impose their own forecasts for the number of Fed rate hikes that will occur during the next 12 months, and then map that forecast to a reasonable expectation for Treasury total returns. Table 1Treasury Index Total Return Forecasts For example, in a scenario where the Fed lifts rates four times (100 bps) during the next year, given current market pricing the rate hike surprise will be modestly negative.6 Using the historical correlations shown in the Appendix, we map that rate hike surprise to changes in the par-coupon Treasury curve and then use the duration and convexity attributes of each individual index to determine how that shift in the Treasury curve will impact index returns. In the scenario described above we would expect the Treasury Master Index to return +2.13% during the next year. While this is a slightly positive number, it is close enough to zero that it does not provide much insulation from changes in long-dated yields that are unrelated to the near-term path for rate hikes. Further, in the four rate hike scenario, investors moving from the Treasury Master Index to the 1-3 year index need only sacrifice 12 bps of expected return to reduce their duration risk by a factor of three. Such a risk/reward trade-off clearly favors a below-benchmark duration stance on a 12-month investment horizon. Table 2 repeats the same exercise but for the major spread sectors of the U.S. bond market. To estimate spread sector total returns we need to forecast both the shift in the Treasury curve and whether spreads will widen, tighten or remain constant. Specifically, we assume that spreads either widen or tighten by the standard deviation of annual spread changes for each index, calculated using a post-crisis interval. Table 2Spread Product Total Return Forecasts The results show that, in a four rate hike scenario, we should expect 12-month investment grade corporate bond total returns of approximately 3.4%, assuming also that spreads stay flat. In a scenario where the average index spread widens by 42 bps, we should expect total returns of only 1%. Bottom Line: Our simple framework for estimating total bond returns reveals that risk/reward arguments clearly favor below-benchmark portfolio duration on a 12-month horizon. Spread product returns should continue to beat Treasuries for the time being, but the window for outperformance is starting to close. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix Chart 8Change In 1-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 9Change In 2-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise Chart 10Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 5-Year Yield Vs.12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 14Change In 30-Year Yield Vs. 12-Month ##br## Fed Funds Rate Surprise 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", dated May 8, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 6 The 12-month rate hike surprise is defined as the 12-month Fed Funds Discounter less the actual change in the fed funds rate during the following 12 months. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart 1Interest Rate Expectations Last week the Federal Reserve made some necessary tweaks to the language in its statement. Namely, with the year-over-year core PCE deflator now up to 1.88%, the Fed was forced to upgrade its assessment of inflation and note that it has "moved close" to the 2 percent target. To assuage concern that such a change might lead to a quicker pace of rate hikes, the statement also emphasized that the inflation target is "symmetric" and noted that its policy of "gradual increases in the federal funds rate" will continue. While the recent increase in inflation is not sufficient to nudge the Fed away from "gradualism", the more important observation is that yields are still not high enough to discount the Fed's gradual approach (Chart 1). The Fed has tightened policy once per quarter since December 2016, tapering asset purchases in place of a rate hike in September 2017. It should be obvious that, absent an economic shock, one rate hike per quarter is the Fed's definition of "gradual". And yet, the market is still priced for barely more than two hikes for the balance of 2018, and not even two rate hikes for all of 2019! Maintain a below-benchmark duration stance until the market comes to grips with the Fed's gradualism. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 4 basis points in April, bringing year-to-date excess returns up to -77 bps. The Corporate index option-adjusted spread tightened somewhat in the first half of April, but widened anew during the past couple of weeks and recently made a new high for the year. Despite this sell-off, valuation remains expensive for investment grade corporates. The 12-month breakeven spread for an A-rated bond has only been tighter 27% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 28% of the time. We are preparing to cyclically scale back our corporate bond exposure, and will start the process once TIPS breakeven inflation rates reach our target range, signaling that monetary conditions are sufficiently restrictive. Our target range is 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Those rates currently sit at 2.16% and 2.23%, respectively. In a recent report we noted that corporate bond excess returns fall sharply once the 2/10 Treasury yield curve flattens to below 50 bps, though they typically remain positive until the curve actually inverts.1 The 2/10 Treasury slope currently sits at 45 bps. That same report also notes that while the outlook for corporate revenue growth is strong, rising employee compensation costs will likely soon put a dent in profit margins and cause gross leverage to resume its uptrend (panel 4). This will apply further widening pressure to spreads later in the year. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in April, bringing year-to-date excess returns up to 102 bps. The average index option-adjusted spread tightened 16 bps on the month, and currently sits at 343 bps. The 12-month trailing speculative grade default rate moved higher for the second consecutive month, hitting 3.92% in March. Moody's baseline forecast still calls for it to fall to 1.7% by March of next year. Based on Moody's default rate projection and our estimate of the recovery rate, we forecast High-Yield default losses of 0.85% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an unchanged junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -140 bps during this time horizon, and 100 bps of spread tightening would lead to an excess return of +654 bps. However, such a large spread tightening is almost certainly over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cyclical lows (top panel). This would be consistent with behavior typically seen late in the cycle, once the 2/10 Treasury slope flattens to below 50 bps.2 MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 18 basis points in April, bringing year-to-date excess returns up to -22 bps. The conventional 30-year zero-volatility MBS spread tightened 4 bps on the month, split between a 1 bp tightening of the option-adjusted spread (OAS) and a 3 bps decline in the compensation for prepayment risk (option cost). While mortgages are no longer excessively cheap compared to corporate credit (Chart 4), we still see limited potential for spread widening during the next 6-12 months. Rising interest rates should serve to limit mortgage refinancing, and muted refis are closely linked to tight MBS spreads (bottom panel). We also view extension risk as relatively limited for conventional 30-year MBS. Using a model of excess MBS returns that we introduced in February, we estimate that despite the 25 bps increase in duration-matched Treasury yields that occurred in April, extension risk trimmed only 2 bps off monthly excess returns.3 Our excess return Bond Map also shows that conventional 30-year MBS require far fewer days of average spread tightening to earn 100 bps of excess return than most other Aaa-rated structured products (Non-Agency Aaa-rated CMBS being the exception), although they are also more likely to deliver losses. But given the benign refinancing back-drop, we remain reasonably positive on the sector.4 Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 9 basis points in April, dragging year-to-date excess returns down to -7 bps. Sovereign debt underperformed the Treasury benchmark by 37 bps on the month, while Foreign Agencies underperformed by 15 bps and Domestic Agencies underperformed by 14 bps. Local Authorities delivered 14 bps of outperformance and Supranationals bested duration-equivalent Treasuries by 5 bps. Dollar strength hurt the performance of Sovereign debt last month, and relative valuation continues to show that Sovereigns are expensive relative to similarly-rated U.S. corporate bonds (Chart 5). We remain underweight USD-denominated Sovereign debt. Conversely, Foreign Agencies and Local Authorities continue to offer very attractive spreads, especially considering the duration and spread volatility characteristics of those sectors. Our excess return Bond Map shows that both sectors offer a superior risk/reward trade-off than the Barclays Aggregate and almost all of its components.5 The large presence of state-owned energy companies in the Foreign Agency sector means it should also benefit from higher oil prices in the coming months. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 65 basis points in April, bringing year-to-date excess returns up to 94 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% in April as fund inflows returned to the sector (Chart 6). Persistently low visible supply is also contributing to the strong technical environment for yield ratios. The tax-adjusted yield for a 10-year municipal bond is now about 46 bps below the yield offered by an equivalent-duration corporate bond. As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.6 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.7 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve rose considerably in April, steepening a touch out to the 5-year maturity point and flattening thereafter. The 2/10 Treasury slope flattened 1 basis point in April, and currently sits at 45 bps. The 5/30 slope flattened 9 bps on the month and currently sits at 34 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the slope of the yield curve during the next six months. With the 10-year TIPS breakeven inflation rate at 2.16%, it remains slightly below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. It will be difficult for the yield curve to flatten aggressively until that target is met. After that, curve flattening becomes much more likely. We continue to recommend a position in the 5-year bullet versus the duration-matched 2/10 barbell, primarily due to extremely attractive starting valuation. Our model suggests that the 2/5/10 butterfly spread is priced for 17 bps of 2/10 curve flattening during the next six months (Chart 7). With long-maturity TIPS breakevens still below target, we think that is too high a bar. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 93 basis points in April, bringing year-to-date excess returns up to 161 bps. The 10-year TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.16%. The 5-year/5-year forward TIPS breakeven inflation rate increased 6 bps and currently sits at 2.23%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.8 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in inflation continues, then this re-anchoring will occur relatively soon. The annualized 6-month rate of change in the trimmed mean PCE deflator has already returned to the Fed's target, and the annual rate of change jumped from 1.71% to 1.77% in March (Chart 8). Pipeline measures of inflation pressure also continue to strengthen. Our Pipeline Inflation Indicator is in a strong uptrend and the prices paid component of the ISM manufacturing survey is closing in on 80, a level last seen in 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to -6 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 40 bps, 7 bps above its pre-crisis low. Our recently introduced excess return Bond Map shows that both Aaa-rated credit card and Aaa-rated auto loan ABS exhibit lower risk and less potential for gains than the Barclays Aggregate index.9 It also confirms that credit card ABS are somewhat more attractive than auto loan ABS, offering approximately the same potential for excess return with less risk. Compared to other fixed income sectors, Aaa-rated ABS offer greater potential return and higher risk than Agency CMBS, Domestic Agencies and Supranationals. But the ABS sector also has a less attractive risk/reward profile than the Foreign Agency, Local Authority and Investment grade corporate sectors. Fundamentally, while consumer delinquencies remain low, they are heading higher alongside a rising household debt service coverage ratio (Chart 9). The persistent (though mild) deterioration in credit quality causes us to maintain a neutral allocation to the sector, despite reasonably attractive valuations. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in April, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month and currently sits at 69 bps, close to one standard deviation below its pre-crisis mean. Our excess return Bond Map shows that Aaa-rated non-Agency CMBS offer greater potential reward, but also greater risk, than the majority of other high-rated spread products. The exception is conventional 30-year Agency MBS, which offer a less attractive risk/reward trade-off.10 That being said, the fundamental picture for commercial real estate is less appealing than on the residential side. CMBS spreads continue to diverge from commercial property prices (Chart 10). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 26 basis points in April, bringing year-to-date excess returns up to 12 bps. The index option-adjusted spread was flat on the month and currently sits at 47 bps. According to our Bond Map, Agency CMBS offer greater potential excess return and less risk than both the Supranational and Domestic Agency sectors. We continue to view the Agency CMBS space as an attractive low-risk spread sector. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.70%. The drop in the model's fair value stems from a decline in the global PMI to 53.5 from a recent peak of 54.5. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, the model will break down and consistently produce fair value readings that are too low. We suspect that we may be reaching this point. When we augment our model with an additional variable to measure the degree of resource utilization, in this case the employment-to-population ratio, we find that the new model projects a fair value of 3.28% for the 10-year Treasury yield (Chart 11). This 3-factor model would not have worked as well as our 2-factor model during the zero-lower bound period, as can be seen by looking at how rolling regression betas from each of the three variables moved sharply following the recession (bottom three panels). However, as we move further away from the zero-lower bound we expect the regression coefficients to return to pre-crisis levels, meaning that it will be important to monitor both trends in global growth and the amount of resource slack in the economy. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 For details on the Bond Map please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
Highlights Corporate Bonds & The Yield Curve: Corporate bond excess returns fall sharply once the yield curve flattens to below 50 basis points, though they typically remain positive until the yield curve inverts. Interestingly, excess returns for equities relative to Treasuries exhibit the opposite pattern. Corporate Bonds & Leverage: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year, meaning that leverage is likely to rise. Rising leverage will be a signal to reduce exposure to corporate bonds. Bond Map: We perform a back-test to assess the effectiveness of the Bond Map framework for sector allocation that was introduced in last week's report. Feature It's been a while, but last week's bond market performance was reminiscent of an old fashioned risk-on phase. The 10-year Treasury yield reached its highest level since early 2014, causing a temporary halt in the yield curve's flattening trend. Spread product also responded to investor optimism, and returns from the investment grade corporate bond index now lag the duration-equivalent Treasury index by only 52 basis points year-to-date, up from a mid-March trough of -94 bps (Chart 1). High-Yield index returns also rebounded, and that index is now outpacing Treasuries by +150 bps so far this year. Chart 1Corporate Credit: Annual Excess Returns But for corporate bond investors, now is not the time for complacency. Out of the criteria we use to signal turns in the credit cycle, we are progressively checking more and more off our list.1 Spreads are already tight relative to history and corporate debt levels are already high. That much has been true for some time. Next up, we await a more restrictive monetary policy and a more severe slow-down in corporate profit growth to below the pace of corporate debt growth. Both of those conditions also need to be met before corporate defaults start to occur and spreads start to widen materially. In this week's report we consider each of those two conditions in turn, noting the triggers that will need to be hit for us to downgrade our current overweight allocation to corporate bonds. Condition 1: Restrictive Monetary Policy Chart 2Monetary Policy Not Yet Restrictive On the monetary policy front, we expect that monetary conditions will turn restrictive in the not-to-distant future (Chart 2). For the time being, long-maturity TIPS breakeven inflation rates are still below levels that are consistent with the Fed achieving its 2% inflation target. The 10-year TIPS breakeven inflation rate is currently 2.17% and the 5-year/5-year forward TIPS breakeven inflation rate is 2.24%. But once both of those rates reach a range between 2.3% and 2.5%, they will be consistent with well-anchored inflation expectations and the Fed will have one less reason to stay cautious. We will start paring exposure to corporate bonds once both the 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate cross above the 2.3% threshold. The re-anchoring of inflation expectations will also impart further upside to nominal Treasury yields, and we therefore maintain our below-benchmark duration stance and continue to follow the road-map laid out in our February report detailing the two-stage Treasury bear market.2 Another traditional signal of restrictive monetary policy is a flat or inverted yield curve (Chart 2, panel 2). Intuitively, a very flat yield curve tells us that the market expects very few (if any) Fed rate hikes in the future. An inverted yield curve tells us that the market actually anticipates rate cuts. While the yield curve is not yet close to inverting, it is approaching levels that are consistent with much lower (and often negative) excess returns for both investment grade and high-yield corporate bonds, as is discussed below. A third indicator of the stance of monetary policy is simply the spread between the real federal funds rate and an estimate of its equilibrium level - the level consistent with neither an accommodative nor a restrictive policy stance (Chart 2, bottom panel). While the fact that the real fed funds rate is currently quite close to the popular Laubach-Williams estimate of its equilibrium level certainly reinforces our view that policy is almost restrictive, the large degree of uncertainty inherent in this sort of estimate leads us to prefer the market signals from the slope of the yield curve and TIPS breakeven inflation rates when forming an investment strategy. The Yield Curve And Corporate Bond Returns To assess the importance of the yield curve as a predictor of turns in the credit cycle, we split each cycle going back to the mid-1970s into regimes based on the yield curve slope. We then calculate excess returns during each phase for both investment grade and high-yield corporate bonds, as well as the stock-to-bond total return ratio. We use the 3/10 yield curve slope instead of the more often quoted 2/10 slope because it allows for the inclusion of more historical data. This decision did not materially impact the results of our analysis. Chart 3 shows how we divided each cycle into three phases: Chart 3Corporate Bond Performance And The Yield Curve Phase 1 runs from the end of the previous NBER-defined recession until the slope crosses below 50 bps. Phase 2 runs from the time that the slope crosses below 50 bps until it crosses below zero. Phase 3 runs from the time that the yield curve first inverts to the start of the next recession. Notice that we do not include recessionary periods in our analysis, usually the periods with the worst excess corporate bond returns. The results of our analysis are shown in Table 1, and the first obvious result is that corporate bond excess returns are much higher in Phase 1 than in Phase 2, although Phase 2 returns are usually still positive.3 Negative excess returns occur more often than not in Phase 3, after the yield curve has inverted. Table 1Risk Asset Performance In Different Yield Curve Regimes The biggest exception to the above observations is that Phase 2 High-Yield returns actually exceeded Phase 1 High-Yield returns in the 2001-07 cycle. In our view, this exception results from the fact that corporate profit growth was well above corporate debt growth in 2005, and did not really decline until 2007, shortly after the yield curve inverted. In contrast, Phase 2 returns were exceptionally weak in the prolonged period between 1994 and 2000. In this instance, corporate profit growth actually fell below corporate debt growth in 1998, well before the yield curve inverted in 2000. This reinforces that both the stance of monetary policy and the trend in corporate leverage matter for corporate bond returns. The latter is discussed in the next section of this report. Another interesting result shown in Table 1 is that the pattern of stock market excess returns over Treasuries is the mirror image of the pattern in corporate bond excess returns. The stock market tends to perform better in Phase 2 than in Phase 1, and often even performs well in Phase 3 after the yield curve has inverted. This means that multi-asset investors should consider paring exposure to corporate bonds relative to Treasuries before they think of reducing exposure to the stock market. Bottom Line: Restrictive monetary policy is one condition that must be met before we reduce exposure to corporate bonds in our recommended portfolio. The first indication of this will likely be the re-anchoring of long-maturity TIPS breakeven inflation rates in a range between 2.3% and 2.5%. We will start paring exposure to corporate bonds when that occurs. The slope of the yield curve is already at levels that are consistent with very low excess returns. Though we demonstrate that an inverted yield curve is historically linked to even lower returns. Conviction that the yield curve is about to invert will be another trigger to further reduce corporate bond exposure in the future. Condition 2: Rising Leverage The second condition that will cause us to take even more credit risk off the table is when gross leverage for the nonfinancial corporate sector - calculated as total debt over pre-tax profits - enters an uptrend. Chart 4 shows that periods of spread widening almost always coincide with rising gross leverage, or put differently, periods when the rate of debt growth exceeds the rate of profit growth. Profit growth has kept pace with debt growth during the past few quarters, causing leverage to flatten-off and allowing corporate spreads to narrow. Going forward, the outlook for top-line corporate revenue growth (a.k.a. net value added) remains favorable, owing to an ISM index that is well above the 50 boom/bust line and still climbing (Chart 5). But on the expense side of the ledger, employee compensation - the largest expense for the corporate sector - is also poised to increase in the months ahead. Unit labor costs jumped sharply in the fourth quarter of 2017 (Chart 5, panel 2), and with the unemployment rate at 4.1% and the economy still adding jobs at a robust pace - nonfarm payrolls have increased by an average of +211k during the past six months - a further acceleration in employee compensation is likely this year. Chart 4Corporate Leverage Has Flattened Off Chart 5Wage Growth Will Hamper Profits The key question then becomes whether corporations will be able to offset rising compensation costs by lifting prices. This remains uncertain, but early indications are not favorable. Our Profit Margin Proxy - the growth in the corporate sector's implicit selling price deflator relative to the growth in unit labor costs - does an excellent job tracking pre-tax profits (Chart 5, bottom panel). At the moment, this indicator signals that profit growth will moderate in the coming quarters. Bottom Line: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year. A decline in the rate of profit growth to below the rate of corporate debt growth will be another signal to reduce exposure to corporate bonds. The Bond Map Back-Test Last week we introduced the BCA Bond Map, a graphical depiction of the current risk/reward trade-off on offer from the different sectors of the U.S. bond market.4 To summarize, in our excess return Bond Map we plot the number of days of average spread tightening required for each sector to earn 100 bps of excess return on the vertical axis, and the number of days of average spread widening required for each sector to lose 100 bps versus Treasuries on the horizontal axis (Chart 6). The diagram is then split into four quadrants based on the location of the Bloomberg Barclays Aggregate index, which we have modified to also include junk bonds. The upper-left quadrant, which we label "Best Bets", contains those sectors that offer less risk and greater excess return potential than the benchmark. The upper-right quadrant, which we label "Exciting", contains those sectors that offer higher risk than the benchmark but also higher potential returns. The bottom-left ("Boring") quadrant contains those sectors with low risk of losses but also low probability of gains, and the bottom-right ("Avoid") quadrant contains those sectors with higher risk than the benchmark and lower expected returns. As can be seen in Chart 6, the current excess return Bond Map shows that Local Authorities, Foreign Agencies and investment grade corporate bonds offer the best combination of risk and expected return. No sectors currently plot in the "Avoid" quadrant. Chart 6Excess Return Bond Map (As Of April 20, 2018) This week, we publish the results of a back-test of the real time performance of our Bond Map. To do this we produced the Bond Map at the beginning of each calendar year starting in 2006 and then calculated average excess returns for each quadrant. For example, if three sectors were in the "Best Bets" quadrant at the beginning of the year, we calculated 12-month excess returns for each sector and then averaged them together to get an excess return for "Best Bets" sectors that year.5 Table 2 shows the average and standard deviation of calendar year excess returns for each quadrant, using a sample that spans from 2006-2017. As would be expected, the "Exciting" quadrant displays the highest average excess return, but also the highest standard deviation. Conversely, the "Boring" quadrant delivers the lowest average return and the lowest risk. The performance of the "Best Bets" quadrant is somewhere in between, delivering a greater average return than the "Boring" quadrant with less risk than the "Exciting" quadrant. Although the Sharpe Ratio for the "Best Bets" quadrant turns out to be worse than the Sharpe ratio for both the "Exciting" and "Boring" quadrants. This provides some support for the investment strategy of favoring either the "Exciting" or "Boring" quadrants depending on your assessment of the macro environment. The "Avoid" quadrant actually delivered negative excess returns on average, with elevated risk. Table 2Excess Return Bond Map Track Record (2006-2017) For comparison we also show the average and standard deviation of excess returns for the Bloomberg Barclays Aggregate index, augmented with High-Yield. The benchmark delivered excess returns only slightly greater than the "Boring" quadrant, with significantly more risk. The total return version of the Bond Map is shown in Chart 7. This is identical to the excess return Bond Map, except it shows the number of days of average increase/decrease in yields for each sector to lose/earn 5% total return. We perform the identical back-test as with the excess return map, and display the results in Table 3. Chart 7Total Return Bond Map (As Of April 20, 2018) Table 3Total Return Bond Map Track Record (2006-2017) Here we see the interesting result that the average total returns are higher in the "Best Bets" quadrant than in the "Exciting" quadrant, but strangely the "Best Bets" quadrant also delivered greater volatility. The "Boring" quadrant delivered the best Sharpe Ratio, while the "Avoid" sector delivered both lower average returns and greater volatility than the "Boring" quadrant. For comparison, the average total returns for the Aggregate index (plus High-Yield) were lower than the total returns from any of the four quadrants, but also with less volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We define the "turn" in the credit cycle as when corporate defaults start to occur and corporate spreads enter a sustained widening phase. 2 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 For the Phase 1 period in Cycle 2 we use an interval of June 1983 to July 1988 because High-Yield excess returns are only available starting in June 1983. In reality, the Phase 1 period should have started when the prior recession ended in December 1982. Using the correct interval (starting in December 1982) investment grade corporate bond excess returns are +131 bps and the stock-to-bond ratio returns are +5.19%, both annualized. 4 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 5 We started our back-test sample in 2006 even though our sector data goes back to 2000. Because our bond map relies on historical estimates of spread/yield volatility, we wanted a sample of at least five years of data before starting the test. With each passing year more back-data is incorporated into our spread/yield volatility estimates, which should improve the Bond Map's accuracy over time. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Global corporate bond markets have seen both ups and downs so far in 2018. Credit spreads in the developed markets and emerging markets, both for investment grade (IG) and lower quality credit tiers, tightened in January. This was followed by a sharp widening of spreads in the two months after the "VIX spike" in early February. Spreads have begun narrowing again in April, but remain above levels that began the year in all major countries with one notable exception - U.S. high-yield. Feature The volatility in corporate credit is a reflection of the growing list of investor worries, coming at a time when yields and spreads still remain near historically low levels in almost all markets. Topping that list is the fear that low unemployment and rising inflation rates will force the major central banks to maintain a more hawkish (or, at least, less dovish) policy bias in the medium term, even with the global economy losing some upside momentum so far this year after a robust 2017. Add in other concerns over U.S. trade policy (i.e. tariffs), U.S. fiscal policy (i.e. wider deficits, more U.S. Treasury issuance) and even signs of potential stresses in global funding markets (i.e. wider LIBOR-OIS spreads), and it is no surprise that more uncertain investors have become less comfortable with the risks stemming from credit exposure. This can be seen in the volatility of mutual fund and ETF flows into riskier bond categories like U.S. high-yield (HY), which saw a whopping -$19.8bn in outflows in Q1/2018, but has already seen +$3.8bn in inflows in April - possibly in response to the surprisingly strong results seen in Q1 U.S. corporate earnings reports.1 Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. In this CHM Chartbook, we introduce new country coverage to our CHM universe, adding a bottom-up measure for Japan and both top-down and bottom-up CHMs for Canada. After these new additions, we now have CHMs covering 92% of the Barclays Bloomberg Global Corporate Bond Index universe, based on country market capitalization weightings. The broad conclusion from the latest readings on our CHMs is that global credit quality has enjoyed a cyclical improvement in response to the coordinated growth seen in 2017, but with important geographical differences (Chart 1): Chart 1Global Corporates: Now Supported##BR##By Growth, Not Central Banks Credit quality in the U.S. has improved on the back of the solid performance of U.S. profits over the past year, but high leverage and low interest coverage suggest corporates are highly vulnerable to any slowing in economic growth Underlying credit quality in euro area corporates remains supported by low interest rates and the easy money policies of the European Central Bank (ECB), but the CHMs are trending in the wrong direction due to poor profitability metrics - most notably, a very depressed return on capital - and rising leverage among core European issuers U.K. corporate health continues to benefit from a very robust short-term liquidity position, although sluggish profitability and weak interest coverage suggest potential medium-term problems beneath the surface Japanese corporates are in good shape, enjoying strong interest coverage and low leverage, although absolute levels of profitability remain much lower than the other countries in our CHM universe Canadian corporate health has enjoyed some modest cyclical improvement, but low absolute levels on profitability and interest coverage, combined with high leverage, point to underlying risks. Looking ahead, the tailwinds that have supported corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds. Inflation expectations are moving higher in most countries, fueled by low unemployment rates and rising oil prices. This is most evident in the U.S., where the additional boost to growth from fiscal stimulus will keep the Fed on its rate hiking path over the next year. A mild inflation upturn is also visible in the euro area and Japan, where the ECB and Bank of Japan (BoJ) are already contributing to a less favorable liquidity backdrop for corporates by reducing the pace of their asset purchases. That trend is projected to continue over the next year, to the detriment of credit market returns that have been boosted by those unusual monetary policies (see the bottom panel of Chart 1). At some point within the 6-12 months, more hawkish central banks will act to slow global economic growth, triggering a more fundamental underperformance of corporates versus government bonds. For now, the backdrop remains supportive, but the clock is ticking as the end of this credit cycle draws closer. U.S. Corporate Health Monitors: A Cyclical Improvement, But Underlying Problems Persist Our top-down CHM for the U.S. has been flashing "deteriorating health" for fourteen consecutive quarters dating back to the middle of 2014 (Chart 2). Yet there has been a modest cyclical improvement seen in many of the individual CHM ratios over the past couple of years - most importantly, return on capital and profit margins - helping push the top-down level to close to the zero line. It is important to note that, due to delays in the reporting of the data used in the top-down U.S. CHM, the latest reading is only from the 4th quarter of 2017.2 A move into "improving health" territory in the 1st quarter of 2018 would require additional increases in cyclical profitability measures. This will be difficult to achieve with U.S. economic growth cooling off a bit in the first three months of 2018 (although the enactment of the Trump corporate tax cuts will likely help support the after-tax measure of margins used in the top-down CHM as 2018 progresses). From a longer-term perspective, the fact that the top-down CHM return on capital metric is well off the post-crisis peak is a disturbing development, given that non-financial corporate profit margins have been stable over the same period. This suggests a more fundamental problem with weak U.S. productivity growth and lower internal rates of return on marginal investments for companies, which is a longer-term concern for U.S. corporate health when the economic growth backdrop becomes less friendly. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also both improved, with the HY indicator sitting right at the zero line. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term problems of high leverage and low returns on capital are not going away. In particular, HY interest and debt coverage remains near multi-decade lows. Chart 2Top-Down U.S. CHM:##BR##A Cyclical Pause Of A Structural Deterioration Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##A Bit Better, But Still Deteriorating What is rather worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of debt has now expanded to a point where the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or the U.S. experiences a major economic downturn. Interest costs would rise while earnings deteriorate, which would push interest coverage to historic lows, as was discussed in a recent report from our flagship Bank Credit Analyst service.3 For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after U.S. inflation expectations rise to levels consistent with the Fed's inflation target (i.e. when both the 5-year/5-year forward U.S. TIPS breakeven and the outright 10-year TIPS breakevens reach 2.4-2.5%). This will give the Fed confidence to follow through on its rate hike projections, pushing the funds rate to restrictive levels. In turn, that will dampen future corporate profit expectations and raise risk premiums on U.S. corporate bonds. With those breakevens now sitting at the highest point in four years (2.19%), that tipping point for credit markets is drawing nearer. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##A Strong Cyclical Improvement Chart 5The Beginning Of The End Of##BR##The U.S. Credit Cycle Euro Corporate Health Monitors: Getting Better Thanks To The Economy & The ECB Our top-down Euro Area CHM remains in "improving health" territory, as it has for the entire period since the 2008 crisis. The trend in the indicator has been steadily worsening since 2015, however, and the top-down CHM now sits just below the zero line (Chart 6). The steady deterioration of the top-down CHM is due to declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity and interest coverage, which are being supported by the easy money policies of the ECB (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Compared to the top-down CHMs we have constructed for other countries, there is an even longer lag on data availability from euro area government statisticians. Our top-down euro area CHM is only available to the 3rd quarter of 2017 and, therefore, does not reflect the strong performance of the euro area economy at the end of last year. Our bottom-up versions of the euro area CHMs for IG (Chart 7) and HY (Chart 8), which are based on individual earnings data that is more timely, both show that corporate health continued to improve at the end of 2017. Return on capital for euro area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, similar to the level in the bottom-up U.S. IG CHM but higher than the equivalent measures in our U.K., Japan and Canada CHMs. Both interest coverage and liquidity ratios for euro area IG are also close to U.S. IG levels. The euro area HY CHM is also showing improvement though declining leverage, although these results should be interpreted with caution as the sample size is relatively small. Chart 6Top-Down Euro Area CHM:##BR##Health Improving At A Diminishing Rate Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Steady Improvement Within the Euro Area, our bottom-up CHMs show that the gap has closed between issuers from the core countries versus those in the periphery, but all still remain in the "improving health" zone. (Chart 9). Return on capital, interest coverage and debt coverage are higher in the core, while liquidity is better in the periphery despite more highly levered balance sheets. Chart 8Bottom-Up Euro Area High-Yield CHMs:##BR##Steady Improvement As Leverage Declines Chart 9Bottom-Up Euro Area IG CHMs:##BR##Core Vs. Periphery While all of our euro area CHMs are indicating healthier balance sheets, that fact is already discounted in the low yields and tight spreads for both IG and HY issuers (Chart 10). Euro area corporates are also benefitting from the supportive bid of the ECB, which buys credit as part of its asset purchase program. We expect the ECB to fully taper its government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. That would be a scenario that could be keep euro area credit spreads tight, although the momentum in the euro area economy will likely be the more important driver of credit valuations. If the soft patch in growth seen in the first few months of 2018 continues in the coming months, euro area credit spreads would likely widen, although by less than if the ECB was not buying corporates. We have preferred to own U.S. corporates over Euro Area equivalents for much of the past year. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although that has not yet flowed through into any meaningful outperformance of U.S. IG and HY corporates. Chart 10European Credit:##BR##Spreads & Yields Have Bottomed Out Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: Still No Major Causes For Concern The top-down U.K. CHM remains firmly in the "improving health" zone, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital remains near 20-year lows around 6%, however, mirroring levels seen in this ratio in the CHMs for other countries. Profit margins remain at 20%, near the middle of the historical range. U.K. credit has benefitted from highly stimulative monetary policy settings by the Bank of England (BoE) - especially after the 2016 Brexit shock when the central bank not only lowered policy rates, but announced bond buying programs for both Gilts and U.K. corporates. The BoE has begun to take back some of that monetary easing by raising rates 50bps since last November. However, we remain skeptical that the central bank will be able to deliver much additional tightening over the rest of 2018 given sluggish growth, falling realized inflation and lingering Brexit uncertainties weighing on business confidence. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet both yields and spreads have been drifting higher in recent months, mirroring the trends seen in other global corporate bond markets (Chart 13). It is difficult to paint a scenario of renewed outperformance of U.K. credit versus Gilts without a fresh catalyst like accelerating growth or monetary easing. Yet the combination of accommodative monetary policy with a solid credit backdrop leads us to maintain a neutral recommendation on U.K. corporate debt. Chart 12U.K. Top-Down CHM:##BR##Steady Improvement Chart 13U.K. Credit: Yields & Spreads##BR##Are Drifting Higher Japan Corporate Health Monitor: A Small, But Very Healthy, Market We introduced our Japan CHM in a recent Weekly Report.4 We only have a bottom-up version of the indicator at the moment, as there is not the same consistency of top-down data sources as are available in other countries. Furthermore, the Japanese corporate bond market is small, as companies have historically chosen to borrow money (when needed) through bank loans and not bond issuance. This means that we have a much more limited amount of data available with which to build a Japan CHM, which covers only 43 companies and only goes back to 2006. The Japan CHM has been in "improving health" territory for the past decade, driven by very healthy liquidity levels and rising return on capital and interest coverage (Chart 14). While the trend in the latter two ratios differs from what is shown in all CHMs for other countries, it is noteworthy that Japan's return on capital has risen to a "high" level (6%) that is similar to the current historically low levels in the U.S. and Europe. The comparison is even less flattering when looking at profit margins, which have been steadily improving over the past five years but are only around 6% - less than half the levels seen in the bottom-up IG CHMs for the U.S. and Europe. Turning to the corporate spread, it has slightly widened in 2018, but by a far smaller amount than seen in other corporate bond markets (Chart 15). We have shown that Japanese corporate spreads are highly correlated to the level of the yen. The direct effect is obvious, as a stronger yen will hurt the competitiveness and profitability of the exporter-heavy Japanese non-financial corporate sector. Yet a strong yen is also a reflection of the market's belief in the next move by the BoJ with regards to Japanese monetary policy. On the front, we continue to expect the BoJ to maintain a very dovish policy stance, with no change in the central bank's interest rate targets (both for short-term interest rates and the 10yr JGB yield). The bigger issue will be if the current softness in the Japanese economic data turns into a broader trend, which would damage corporate profits and likely result in some widening of Japanese credit spreads. Chart 14Japan Bottom-Up CHM:##BR##Very Healthy Chart 15Japanese Corporates##BR##Will Continue To Outperform JGBs Canada Corporate Health Monitor: In Good Shape On A Cyclical Basis In this CHM Chartbook, we are introducing new CHMs for Canada. Like Japan, this is another relatively small market. Canadian corporates represent a slightly larger share of the Bloomberg Barclays Global Investment Grade Corporate Bond Index (5%) than Japan (3%). The average credit rating of the Canadian corporate bond index is A2/A3, which is higher quality than that of the U.S. IG index with but with similar credit spreads over their respective government bonds. However, due to the lack of liquidity and market accessibility, Canadian corporates are considered a niche market that has not gained much attention from global investors. We created both a top-down and bottom-up version of the Canada CHM. For the bottom-up CHM, we gathered data on 85 companies from both the Bloomberg Canadian dollar-denominated IG and HY indices. We combined IG and HY bonds into one set of data given the small sample sizes of each category, which also allows us to compare it to the top-down Canadian CHM that does not distinguish by credit quality. Both Canadian CHMs are firmly in the "improving health" territory (Chart 16). Unsurprisingly, these CHMs have shown a reasonably strong correlation to oil prices, which are a key driver of the Canadian economy through the energy sector. This can be seen in the deterioration in the CHMs after global oil prices collapsed in 2014/15, and the subsequent improvement as oil prices have recovered over the past couple of years. Going through the individual CHM components, leverage has been steadily rising and currently sits around 100%. While Canada's problems with high household debt levels are well known, the Bank for International Settlements (BIS) noted in its March 2018 Quarterly Review that high Canadian corporate leverage could also pose a future problem for the Canadian economy.5 Among the other CHM ratios, return on capital and profit margin have fallen for nearly a decade, although there has been some moderate improvement of late thanks to higher oil prices. Debt coverage and interest coverage are also showing some very moderate recovery due to low interest rates - a trend also observed in other countries where central banks have maintained easy monetary policy. Canadian corporate bond valuations are not cheap at the moment, with the index spread around decade-lows of 100bps (Chart 17). BCA's commodity strategists expect global oil prices to continue climbing over the next year, which should support Canadian corporate valuations versus government bonds given past correlations. We also expect the Bank of Canada to continue to slowly raise interest rates over the next year, as well, mimicking moves we also anticipate from the U.S. Federal Reserve. Given the cyclical signs of improving corporate health from our Canadian CHMs, and our bearish views on Canadian government bonds, we are upgrading our recommended allocation on Canadian corporates to overweight while downgrading governments. This is strictly a carry trade, however, as we do not anticipate spreads narrowing much from current levels. Chart 16Canada CHMs:##BR##Cyclical Improvements, Structural Problems Chart 17Canadian Corporates:##BR##No Cyclical Case For Spread Widening Yet Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.6 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Table 1Definitions Of Ratios##BR##That Go Into The CHMs Appendix Chart 1We Now Have CHM Coverage For 92% Of##BR##The Developed Market Corporate Bond Universe 1 http://lipperalpha.financial.thomsonreuters.com/2018/04/high-yield-bond-funds-attract-investor-attention/ 2 The majority of data used in the top-down U.S. CHM comes from the Federal Reserve's quarterly Financial Accounts Of The United States Z1 release (formerly known as the Flow of Funds), which is typically published in the third month following the end of a quarter. Thus, those data inputs for Q1/2018 will not be available until June. 3 Please see Section II of the March 2018 edition of The Bank Credit Analyst, available at bca.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 5 https://www.bis.org/publ/qtrpdf/r_qt1803.htm 6 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Chart 8Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns