2016 credit investment opportunities in the spotlight

The start of the New Year was far from ideal. The negative sentiment that struck the Chinese market right from start spilled over into equity markets worldwide.

Doubts about the planned soft landing of the Chinese economy arise with widespread implications for global economy. Combined with additional geopolitical aspects, the picture looks complex and investors may have to navigate through stormy seas in 2016.

China has entered center stage again and we expect the country to dominate headlines and drive sentiment as well during 2016. China´s substantial capacity in many industries, which may not follow the same thinking in economic terms and understanding of financial discipline that apply in other markets, provides additional pressure.

The effects are far-reaching and the dependencies built up over the last decade to other economies have formed a vicious cycle, which we expect to continue to play an important role in market sentiment during the year ahead.

The Emerging Markets area, which has been a reliable source of economic growth over the recent past, has to pay for its external dependencies and for building its wealth on commodities now. A reversal is not in sight and we expect the country to remain under pressure. In general we should see continuous volatility in FX with several Emerging Market currencies at risk to continue their downward trend.

In contrast, in the Euro area, stronger private consumption, supported by lower oil prices and easy financial conditions is outweighing a weakening of net exports, which speaks for moderate growth in the area. Across the Atlantic overall activity in the United States should remain robust, supported by still cheap financial conditions and strengthening housing and labor markets.

However, there are also challenges arising from the strength of the dollar, which may put some pressure on the US manufacturing sector. Increasing woes from the domestic energy sector, accompanied by a significant rise in default rates are also in sight. The number of voices stating that the United States may run out of steam latest in 2017 is increasing.

The US is entering its eighteenth year of upswing looks rather late in the economic credit cycles on a macro and micro basis. This, in combination with struggling Emerging Markets, could have far-reaching negative implications for financial markets.

To summarize, the pickup in global economic growth is expected to be weak and uneven across economies, with risks increasingly shifting towards Emerging Markets. In its World Economic Outlook update released on January 19, 2015, the International Monetary Fund (“IMF”) projects global growth to rise by 3.4% in 2016 and 3.6% in 2017, 0.2% weaker to what has been forecasted in October last year.

Against the macroeconomic background the Federal Reserve and the European Central Bank will continue to go on separate ways. With the economy hitting full employment the Federal Reserve finally decided in December to raise the target range for the federal funds rate to 0.25% to 0.5%. We expect additional hikes to follow, as wage and price inflation should inch higher.

Despite the stronger USD and plunging oil prices, price increases in the services-based US economy are more than offsetting the ongoing weakness in goods prices. However, after recent dovish tones from leading Fed representatives – emphasizing the necessity to consider as well the global political and macro picture – we expect a slow Fed hiking cycle.

In the eurozone, the picture is different. 2016 will be the fourth year of inflation hovering around 1% and the additional decline in energy prices foils ECB´s efforts to reach inflation targets. Against this background the likelihood has increased that the ECB will go further by additional easing already in March. However, we think that the ECB policy bears the risk of levelling down, as markets are more driven by speculation on future ECB action than by fundamentals. To avoid liquidity driven bubbles investors should watch this out in 2016.

We expect in particular European credit to outperform against a broad range of assets in 2016. Our preference for European versus US credit is based on the anticipation of an already late economic/credit cycle in the US and the vulnerability of the domestic energy sector, which will lead to significantly higher default rates. This may already become evident somewhere in the second half of the year, reflecting a weaker growth scenario in the US.

On the other hand, the European growth story remains intact and we expect the ECB to provide the market with additional easing, which should spur valuations in addition. In particular for European High Yield, recently suffering from idiosyncratic risk and massive fund outflows, we see a positive momentum in the low yield environment, especially in the BB segment.

In general, we expect the market sentiment to remain a key driver for evaluating credit opportunities and portfolio adjustments for some time ahead. Based on a look at the performance of the BarCap Euro Corporate Index, we can observe that since the beginning of the year the BBB/BBB-rating segment clearly underperformed against its peers. However, neither maturity nor sector affiliation did really matter. We expect this cautious and undifferentiated market stance to prevail at least over the near term. However, these circumstances also create opportunities. “When the dust settles and idiosyncratic risk becomes essential again – as it should be – thorough asset selection will pay.

Lisa Backes, CIO of YCAP Asset Management (Europe)

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