With the Dow falling over 1,000 points in two trading days and significant widening of credit spreads in fixed income, we want to share an update regarding our market views and our approach to investing in this environment.
Broad, undifferentiated selling in U.S. credit has continued in the third quarter, as the sector underperformed Treasuries by 0.53%, or 53 basis points (bps), in July and another 74 bps through August 21. We believe spread widening has been the result of three key factors:
- Fears over a hard landing in China
- Unrelenting new issue supply in an illiquid summer
- Escalation of oil price declines and supply fears
Lock-step spread widening across nearly all industries and among issuers with very different fundamental characteristics are the key symptoms of these conditions. Of roughly 30 Barclays corporate industries, only two posted positive excess returns versus risk-free rates in July.
When the market temporarily ceases to value the nuances of pricing risk, it can result in short term mispricing at the issuer, term structure and sector level. While painful in the short term, these mispricings offer an accompanying opportunity to seek particularly dislocated securities or market segments and progressively position them for a return to rationality.
What has driven the recent credit performance?
While oil price declines appeared to take center stage earlier this year, as it had in the fourth quarter of 2014, the significant underperformance of the Metals and Mining sector this year suggests that fear of a hard landing in China has been the dominant factor driving credit spreads.
Energy is an input to the other commodities producers and, all else equal, should generally be a positive for profitability when prices decline. If energy supply/demand dynamics were the sole driver, it would not explain the tandem widening in both sectors. Further, the extent of the reaction and correlated weakness across industries and issuers is a symptom of illiquid markets. In fact, issuers in Technology and Media suffered significant losses on a virtual absence on relevant new information.
So, how rational are fears of a China hard landing and to what extent has the market reacted to the news?
Concern over a worse-than-expected outcome for growth deceleration has justifiably increased. For example, Chinese PMI, the most watched higher frequency indicator of economic activity, is once more flirting with sub-50 levels. But, the broader question has always been the Chinese government’s willingness and ability to stabilize its economy. We continue to find substantial evidence of our view that a central economy with ample resources and basic economics can make a soft landing achievable.
Classic economic actions like the recent currency devaluation, People’s Bank of China (PBoC) easing, long-term refinancing operations (LTRO)-like programs and more central authority-driven ones like the transfer of some China Securities Finance Corp equities holdings into a sovereign fund to help stabilized markets are potent examples of such actions.
We expect these and future actions to achieve their objectives, but will watch economic activity indicators very closely to test our thesis. For example, we examine commodity demand indicators to help frame our expectations for a return to rationality in spreads.
Below is an index of iron ore deliveries to China. Examining deliveries versus the corporate spreads of one of the largest iron ore producers demonstrates that spreads have widened substantially by both absolute and relative measures even for some of the largest, most effective global producers with competitive cost structures.
From an investment standpoint, we measure and assess risk, price risk and determine whether market prices are over- or undershooting relative to our evaluation. Just as we find that oil prices during the Great Recession provide a reasonable reference for market stress, we look at the relative valuation of Metals & Mining issuers to determine the extent to which the fulcrum of China fears has priced a slowdown.
An example is our analysis that compared option adjusted spreads (OAS) of the Metals and Mining sector to overall corporate option spreads to help frame our relative value assessment. There are only two months since Barclays data became available (1994) when the relationship was wider than at the end of July (1.55): December 2008 and January 2009.
These periods are reasonably viewed as significantly more stressed than today both in terms of fundamental growth expectations and market environment. And while the overall level of spreads was higher then, the relationship between the two does provide a useful reference.
In addition, while brinkmanship between North American and Saudi interests may continue to cause concern, some encouraging signs have evolved. For example, the August report of the three main energy organizations—International Energy Agency (IEA), U.S. Energy Information Administration (EIA), Organization of the Petroleum Exporting Countries (OPEC)—indicated that supply growth declined in July and revised supply outlooks lower. Simultaneously, they revised demand outlook higher, reflecting lower oil prices.
Why does issuance matter?
Corporate debt issuance, according to The Securities Industry and Financial Markets Association (SIFMA), has been almost 15% higher year-to-date through July versus the same period last year. At the current rate, 2015 is on pace for over $1.6 trillion of corporate debt issuance. The issuance of the past three months (May, June, July), typically the beginning of a slower summer period, has exceeded any three-month period in 2014, which was the year with the biggest corporate debt issuance to date.
With so many corporations sharing the same mindset of concern regarding rising interest rates, many rushed to issue debt before their cost of funding rose. With so much focus on interest rates, ironically, the glut of corporate issuance in a lower liquidity environment with weak demand has been the greater risk to fixed income markets.
Weren’t rates supposed to go up?
While much of the recent discussion surrounding fixed income investment has focused on the expectation of rising interest rates, recent market developments and the impact on U.S. equity markets have reemphasized the difficulty in predicting the direction of interest rate moves, particularly in the short run.
The first equity market correction since 2011 has reinforced, in our view, the pitfalls of market timing. We have long been of the opinion that a core fixed income allocation has the role of providing stability to a diversified portfolio and aggressive shortening of duration can diminish its ability to fulfill that critical role. Maintaining a neutral duration and barbelled term structure has been beneficial to our strategies as the market stress has pushed risk-free term structure premia lower.
While credit exposure has underperformed across sectors and securities with little differentiation in the current environment, systematic decision making is the basis of successful investing. In the short run, this environment is predictably difficult for fundamental investors, but a dislocated market offers opportunities as we expect that a return to rationality and stability will also return to security valuation differentiated by fundamentals.
Avoiding reactive risk-averse behavior is as important to long-term results as correctly assessing risks. Such inefficient risk-pricing conditions are particularly well suited for combining top-down and bottom-up analysis to identify attractive risk-adjusted opportunities—the core of our investment approach.
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