Ross Pamphilon, Co-Chief Investment Officer & Portfolio Manager at ECM Asset Management, provides the July credit market overview.
July was a mixed month for risk assets as the positive effect of the last month’s ECB meeting began to wear off. It remains to be seen whether the ECB’s actions will be successful in stimulating the economy but the early indications are that growth and inflation are deteriorating.
The recent sanctions imposed by the European Union and United States against Russia will likely have a negative impact on the growth prospects for the region. Italy slipped back into recession last quarter while June’s German factory orders fell by their most since 2011 providing further evidence that the German economy is being hurt by geopolitical tensions.
Meanwhile, a euroarea consumer price rise of 0.4% is well below the ECB’s 2% target. Central bank actions take time to filter through to the real economy and our expectation is that the ECB will wait for further evidence before any form of quantitative easing is announced.
Furthermore, the ECB’s programme to purchase asset backed securities is unlikely to be in place in the near term so the economic outlook will need to deteriorate significantly from here in order to prompt the ECB into more immediate action.
While the growth prospects for the region remain a concern it does appear that systemic risks emanating from the banking system are now behind us. The ECB has been busy readying its asset quality review which will bring consistency with respect to the way banks measure and disclose their riskier loans.
Bank’s balance sheets will additionally be stress tested under baseline and adverse scenarios and banks will then have two weeks to formulate plans to cover capital shortfalls within the subsequent six months.
Confidence in the regions banks was put to the test during the month after Banco Espirito Santo was rescued in a €4.9bn bailout provided by Portugal’s bank resolution fund. The bailout was significant for two reasons. Firstly, it did not spark off significant volatility in the rest of the regions banks as would certainly have been the case in 2011/12.
Secondly, senior bondholders were protected through a move into a good bank called Novo Bank. Subordinated bonds and shares now reside in the bad bank bearing the losses. The bank resolution fund is backed by Portugal’s banks and the plan is to eventually sell Nova Bank using the proceeds to repay a state loan. Should the proceeds be insufficient then it is the banking sector which is exposed with respect to any shortfall.
Market performance was good in July up until the last few days when we suffered a sudden, correlated and broad based sell off. There was no one single reason behind this but rather a confluence of smaller events ranging from Argentina defaulting on its debt, poor economic data out of Europe and geopolitical risk stemming from the Middle East and Russia.
All this happened at a time when valuations were beginning to look stretched across a number of asset classes. The ensuing sell off was exacerbated by poor market liquidity during the traditional quieter summer months. Reviewing equity market performance, the S&P 500 (-1.4%), DJ Euro Stoxx 600 (-1.6%) and FTSE 100 (-0.1%) indices were all down on the month. European government bonds performed well with gilts (1.1%), bunds (0.6%) and peripheral debt markets outperforming comparable US treasuries which finished the month in modest negative territory. Emerging market equities were mixed with the Shanghai composite + 8.8% on the month while Russia’s Micex index was unsurprisingly down -4.2%.
The credit markets had a mixed month. In investment grade corporates sterling underperformed both euro and US dollar denominated markets. Excess returns (versus governments) for Euro, Sterling and USD denominated investment grade corporates of 17bps, -34ps and 1bps respectively. In high yield, sentiment in the US reversed with Janet Yellen joining others in warning that valuations were looking expensive. Outflows from high yield funds approached $10bn making is the largest monthly outflow since June 2013.
While the US loan market also saw outflows these were relatively modest in the context of the size of the market resulting in a relatively more stable loan market. In the end total returns for US high yield finished the month down -1.32% while the loan market was down -29bps. The euro and sterling denominated high yield markets performed slightly better with euro market down -7bps on the month while sterling high yield lost -41bps.
ECM’s July investment strategy meeting noted signs of fatigue creeping into the markets. New issues have been coming to market at tight spreads and little apparent concession to secondary markets. Also, the quality of new issues has deteriorated over time with smaller size issues and a greater proportion of new entrants coming to the market. In our model portfolio we decided to take risk down focusing on bank capital, subordinated insurance and high yield. The only addition was in investment grade corporates while we also increased our allocation to cash.
In the longer term, a disciplined approach towards security selection and the ability to make effective asset allocation decisions will prove key drivers of investment performance. When we compare European credit to other investment opportunities we continue to believe that the credit markets still represent a relative safe-haven. Certainly, with a number of equity markets being down on a year to date basis the returns and volatility seen in the credit markets look reasonable.
Overall, with the notable exception of US high yield, the credit markets continue to demonstrate their resilience. However, given the backdrop of worsening prospects for eurozone growth together with increased geopolitical risk we expect the markets to remain more volatile going forward. However, credit market fundamentals remain strong and default rates low. In a low growth, low inflation type environment we believe that credit can continue to deliver decent returns going forward.