The year 2020 is proving to be a rollercoaster of a journey. Investors started the year with neutral expectations, with yields hovering near all-time lows and getting sequentially thinner, albeit at a leisurely pace.
Subsequently the pandemic hit, markets panicked and yields soared, as the world fell into economic turmoil due to social distancing and other public health measures. As is the case during a panic situation, there was an over-reaction, and credit markets looked selectively cheap generally in April. The swift and strong central bank support calmed the markets, and risk rallies ensued in many asset classes as investors turned bullish.
It’s hard to believe that all of this happened in less than 6 months, yet here we are. The question on many investors’ minds is where we go from here. Trading last week illustrated the mixed feelings currently present in the markets, with a mini sell-off in reaction to what many commentators believe was over-exuberance in the build up to markets recovering all if its year-to-date losses.
Markets are looking past the expected economic pain in 2020, despite the continued flare ups in virus cases in certain parts of the world threatening the longevity of the re-opening phase of world economies. Markets are even fully pricing in central bank support at this point, therefore it is unlikely that it will continue to dominate market sentiment for the rest of the year.
Given the sharp drop in yields, technicals are looking less attractive. Technicals are defined as the demand for bonds independent of credit fundamentals, which traditionally is driven by the level of bond yields, but increasingly corporate bond purchases by central banks are driving these technicals. Given that these are largely priced in, tail wind effect is expected to be weaker in the second half, as yields become more sensitive to fundamentals.
Indeed, corporate fundamentals are still currently a risk, and will remain so until aggregate demand fully recovers. At this point of the credit cycle corporate liquidity remains paramount. The starting point of liquidity should be the ability of companies to pay off their near term liabilities, modelled with current ratios or more defensively with quick ratios. Fundamentals could be supported in a significant way by supportive European fiscal policy, with strong relief packages being spent by the EU on the most beleaguered economies such as Italy, which has underperformed to date, offering attractive potential upside. In fact peripheral countries are set to benefit most from fiscal moves, especially given that Italian credit tightening has lagged.
Working on the assumption that there will be no significant second wave of virus cases, acknowledging this as a big caveat given the imminent re-opening of travel in Europe, higher beta sectors are expected to outperform in 2H2020. Real estate, financials and other cyclical industries are poised to tighten and outperform in terms of credit spreads. Being selective, and adding beta through lower rated credit on strong conviction is the recommended approach to navigating the second half of the year, as default risk remains disproportionally high, reflected in the weaker recovery of lower rated credit compared to investment grade credit.
Given the general expectations of capital gains in spread tightening, an increase in credit duration by purchasing longer dated bonds, thereby extending down the credit curve, can reward investors based on the assumption that the macro scenario plays out, however key risks to this strategy remain and positions should be adequately measured.
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