The best analogy for our view on 2018 is that risk assets are like a highly skilled
but still relatively inexperienced tightrope walker. Our tightrope walker started his
career immediately after the GFC and earned his apprenticeship in very difficult
conditions with lots of crosswinds but with the knowledge that a huge safety net
existed beneath him. This allowed him to walk across the narrow line with slow
but ever increasing confidence, skill and aplomb. In our analogy the safety net
is the central bank put that has continued to help financial markets’ confidence
over the last several years in spite of very challenging conditions.
However in 2018 our tightrope walker will have to move onto the next phase
of his career where the structural support of the safety net will likely be slowly
weakened. Every time he looks down he’ll figuratively see a central banker loosen
or take away a supporting rope. As such his skills and confidence are likely to be
tested more than in recent years.
Figure 1 shows the rolling 12 month central bank balance sheet size from the big
four DM central banks over the last few years and likely path over the next two.
Assuming fairly neutral and consensus assumptions, central bank balance sheet
growth will fall sharply over the next 12-24 months from the near peak levels
currently seen. Meanwhile we think the risks to inflation are on the upside.
A combination of the two will likely mean that crosswinds pick up as we move
through Q2 and into H2 – a period where US inflation might start to more
consistently beat on the upside (or at least not consistently miss on the downside)
and markets start to think about a June ECB meeting where the end of Euro QE
is possibly announced.
If we’re correct on inflation it’s going to be difficult for central bankers to justify
anything other than the slow and steady removal of the safety net beneath our
intrepid tightrope walker. As such his task will get more difficult purely because
his confidence must surely weaken with more risks associated with any fall. As
such he’s likely to wobble more. So expect volatility to finally start to increase
after surprising many by staying as low for as long as it has done. At this stage the
tightrope walker may have enough skill to safely navigate across to the next point
(end 2018), however the probabilities of such a successful outcome are likely to
be getting lower as the year progresses.
Fortunately growth starts the year on a firm footing and unless there is an external
shock or the steady central bank withdrawal and/or inflation creates a bigger
volatility shock than expected, then the economy will likely ensure that credit
fundamentals remain relatively resilient and the spread widening manageable.
In the near-term we actually think spreads could tighten as crosswinds look light
in Q1 and the recent widening entices investors back into credit. Q1 will likely also
see evidence that CSPP hasn’t been tapered much relative to PSPP. As such this
could mark a fresh round of optimism about the technicals in European credit.
However Q1 might mark the best point of the credit cycle. Things may start to
become more challenging from this point as we leave the perfect scenario of noninflationary
growth and high central bank support behind us. We’ll also likely start
to see markets price in the end to the various ECB programs as Q2 progresses.
Risks
The biggest risks to our view on the positive side is that inflation stays slightly
below expectations and the carry trade continues all year.
The biggest realistic risks on the downside are that the US yield curve flattens
considerably perhaps through a perceived Fed policy error or that China’s
slowdown starts to percolate through to global growth. We go through this in a
bit more detail later in the piece.
Spread forecasts
IG and HY Summary Views
IG highlights
■ Corporate fundamentals remain resilient.
■ Leverage of BBBs has been flat and has only picked up among
higher-rated issuers.
■ Low-rate environment has kept interest coverage elevated across
the board.
■ Rating trends have turned positive.
■ We expect IG technicals to become more challenging in 2018 as the ECB
QE ebbs away. The key question will be timing.
■ Initially, expect carry trades to go on.
■ By next QE decision (June?) and perhaps with more signs of inflation
by then, expect some more volatility and wider spreads.
■ However, negative interest rates in the eurozone will continue to
make IG relatively attractive.
■ For now, we keep carry on, incl. high-beta such as subs/AT1s
■ Prefer CSPP-ineligible bonds over eligibles
■ Ineligibles underperformed recently, expect them to outperform
during the taper.
■ Ineligibles are higher-beta, should perform relatively well during
carry.
■ We would start to gradually reduce credit risk and duration during Q2.
■ Risks are on both sides; we clearly acknowledge that our view means
walking a tightrope.
HY highlights
■ Despite stretched valuations spreads should remain supported through
Q1 but wider by the end of the year as inflation, yields and volatility rise.
■ Marginally negative total returns in the coming year (-0.3%), although
we could see a total return of around +1-1.5% through the first quarter.
■ Fundamentals remain healthy while rating trends have improved. Default
rate to remain low consistent with recent ranges (1-2%).
■ Net issuance may rise on the back growth led investment spending and
M&A, providing a potential headwind to the technicals.
■ But a net flow of rising stars over fallen angels may balance against this
somewhat.
■ After the recent sell-off EUR Bs offer relative value over EUR BBs.
■ Loans to outperform bonds as credit spreads widen, possibly from Q2.