It’s late at night in the smoke-filled club room. Some of your friends have left and few people are still dancing, including yourself. You look at your watch and face a difficult choice: do you leave the room and stop dancing, or give in to the fear of missing out on the party and try to pick the least bad people to dance with?
If you had to think of financial markets in one image, this is how it would look like. The music is good – monetary policy is supportive and capital continues to flow into yield assets – but fundamentals are slowly deteriorating and as a result, central bank liquidity is no longer lifting all boats.
The latest IMF Global Financial Stability Report was full of cautionary tales. It warned about a build up of fragilities in different parts of the financial system vs where they hit in 2008. Banks are more resilient this time around, but leverage has grown across corporate balance sheets. Many investment funds have bought into the same trades, some reaching for yield in less liquid assets.
The Algebris team attended the IMF and World Bank meetings in Washington. This is what we found out from discussions with policymakers from developed and emerging markets:
1. Policymakers are increasingly concerned about long-term fundamentals across corporates and certain EM sovereigns. They admit global manufacturing is in recession: the fear is a potential spill-over to other sectors.
2. Investors are optimistic about a relief of trade tensions, with a temporary US-China agreement and an agreement on Brexit. This eliminates some of the tail risk in financial markets – but the idea that growth may be bottoming is still lacking proof.
3. That said, the question remains open whether it is too late to recover from damage caused by trade tensions, or if this year’s central bank stimulus may be enough to re-ignite growth in 2020. The most promising signals are coming from the US housing market, while data continues to deteriorate elsewhere.
4. Investors are still dancing, perhaps with a bit of complacency. Inflows into passive/liquid and illiquid strategies are growing.
5. Some central banks are pushing back on additional stimulus (e.g. ECB, Banxico, Riksbank), although the general stance remains dovish.
In a context where top-down macro remains supportive thanks to easy monetary policy, but bottom up fundamentals are getting uglier across corporates and certain EM sovereigns, we believe investors need to continue to be in the game, but should be increasingly careful about what they buy. These is how we approach portfolio construction looking at 2020:
1. Investors can keep dancing: there is still some room for interest rates to decline and for spreads to tighten. The opportunities are across selective emerging markets and developed market sovereigns and firms, as we discuss below. Growth remains positive and our base case is of a soft patch for H1 2020, not a recession.
2. That said, fundamentals are deteriorating. Part of the optimism in financial markets comes from a reduction in the left-tail, given the benign outcome in Brexit and US-China negotiations. However, macro data suggests the stabilisation is still a monetary policy trick with little pass-through to the real economy: mortgage refinancing is up but housing starts down versus expectations in the US, bank spreads are down but banks have shown tightening lending standards in Europe, equity indices are up but cyclical/capex and industrial activity remain flat, with Caterpillar just downgrading its earnings outlook. In this environment, investors need to be careful about zombie debt issuers who have survived thanks to low rates but will likely fall flat as growth slows down. Triple-B corporates have grown to over half of US investment grade bond markets, quadrupling in size from pre-crisis levels, to $4.2tn from $936bn at end-2007. Corporate leverage remains high across speculative grade firms too, with large chunks of the high yield market trading at stressed or distressed valuations.
3. Central banks are no longer the only game in town. Over the past few years, the shock and awe of QE lifted all boats up or down. A key lesson we learnt in 2019 is that QE and low rates no longer benefit all borrowers: weak sovereign and corporate balance sheets are starting to crack. Credit markets are increasingly binary: even though the overall level of credit spreads remains stable, 80% of firms in US high yield are either 100bp tighter or wider than the average: this is as much as in 2016.
4. This means investors have to be mindful about where to keep dancing. Argentina and Lebanon are a case in point for emerging market sovereigns, going from tight credits rated as relatively safe in a search-for-yield environment to being rated as distressed. This jump can happen also the other way: Ukraine and Greece, for example, the first two post-populist governments in emerging and developed markets, have experienced a sharp tightening in their spreads this year – Greece going from high yield valuations to issuing debt at negative yield.
5. In this context of benign macro risks but deteriorating bottom-up fundamentals, we think that assets supported by central banks, like emerging market and developed market sovereigns, should outperform. Financial credit may be volatile, however banks have de-risked compared to the last crisis. Like the IMF, we worry about the risk in corporate balance sheets, especially across cyclical sectors which may face macro or regulatory headwinds, like retail/consumer in Europe and the UK or energy and healthcare in the US.
The Easing Cycle Continues in Emerging Markets
At the IMF, EM central bankers sounded more relaxed about easing, as the ongoing global slowdown calls for cuts and inflation concerns have been fading in the second half of the year.
Rates has been the trade this year, but EM central banks moved dovish a bit more slowly than DM counterparts. Comfort with easing is now higher, as global weakness is becoming more concerning for EM and stable currencies and energy prices keep inflation low.
In this environment, we still see value in EM rates where monetary policy has lagged or easing is not fully priced in. Our focus is more selective than earlier this year given the broad move in rates.
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