Macro Perspective

After a turbulent start to the year, global credit markets closed out 2019 on a strong note. Our controversial view early on was that global growth would prove to be resilient and that central bank monetary policy, led by the Fed and ECB, would have to turn much more accommodative to support their respective recoveries. Ultimately, the combination of both of these themes broadly playing out, together with receding fears over Brexit and US-China trade tensions, led to a sharp outperformance of spread sectors globally.

For 2020, we expect global growth to remain resilient on the back of steady US growth, improving domestic conditions in the eurozone and an acceleration in emerging market (EM) growth momentum. Sustained monetary policy accommodation by the Fed and ECB intended to truncate downside growth risks and engineer a pick-up in inflation momentum, combined with receding fears over Brexit and US-China trade tensions, should serve to buoy global financial market sentiment, especially in a period of mounting geopolitical risk. Ultimately, a benign global macro backdrop is favorable for spread sectors and suggests further outperformance versus developed market (DM) government bonds as we move further into the New Year. Admittedly, given 2019’s substantial rally, the lower starting point for both US rates and credit spreads, and new risks on the horizon—specifically, the potential for heightened market volatility on any escalation in Middle East hostilities and as we move closer to the US presidential election in November—we think our overweight positions need to be more modest.

Oil Markets: Geopolitical Risk Once Again on the Rise

The recent flare up in Middle East hostilities—first, a targeted US air strike against a senior Iranian military officer followed by a retaliatory response by Iran with warnings of serious reprisal in the event of further US provocation—has priced new risk premiums into global oil markets. In contrast to oil price behavior following the series of drone strikes against Saudi processing facilities during 3Q19, this development has the potential to materially alter supply and demand fundamentals over the near term. Following these events, Brent and WTI spot prices were up 3.6% and 3.4%, respectively, but have since pulled back on more measured rhetoric between both sides. Longer-dated WTI prices were up less, 0.5%, and flat for 2021 and 2022 averages, respectively, as the market remains concerned about ample oil supplies, weakening longer-term demand and continued producer hedging of out-year production.

While there is a wide range of possible scenarios going forward, we believe WTI oil prices will remain elevated in the $60-$65 per barrel range to account for the additional geopolitical risk premiums. We would expect a more severe move higher in both short-dated and longer-dated crude should further hostilities materially impact regional supplies in Saudi Arabia or Iraq given the countries are the second and fifth largest oil producers in the world, respectively.

Prior to this development, the crude market in 2020 was shaping up to be relatively balanced—resilient oil demand growth, moderating US production growth, announced additional OPEC production cuts and continued geopolitical risks all supportive of oil prices. Concerns over trade tensions and weaker economic growth have since subsided on the back of the “phase one” US/China agreement and the signing of the US-Mexico-Canada Agreement (USMCA), which provide a more reasonable oil demand growth backdrop.

While WTI prices over the short term are expected to be elevated (and volatile) given the supply-side risks, we would expect prices to return to the $50-$55 per barrel range over the medium to longer term given lower demand growth from slowing forward economic activity. The rise in near-dated oil prices should enable US producers to extend hedge protections further into 2020 and 2021, providing a short-term boost to cash flows.

From a portfolio positioning perspective, our focus in the energy segment (investment-grade and high-yield) remains in the midstream where companies continue to benefit from more defensive characteristics including hard asset coverage and fee-based cash flow streams, which are not subject to direct commodity price risk. We remain less constructive on oil field services as exploration and production (E&P) companies have continued to focus on capital discipline and “operating within cash flow” resulting in lower drilling activity—the primary source of earnings. Where investment-grade and high-yield positioning differs slightly is in E&P. Investment-grade E&P offers the size, scale and diversification over high-yield counterparts. However, opportunities in high-yield are expected to present themselves this year, subject to improved terms and structure.

Credit Cycle Pulse

Much ink has been spilled over the past year on where we are in the global credit cycle and whether the party is about to end. Investor concern on this front is understandable, as credit spreads have ground tighter even while corporate sector leverage has crept higher, and as global growth has softened on the back of trade-related uncertainty. This is a potentially worrisome mix, many would argue. We also recognize that there are a number of signs in credit markets that warrant caution, for example: increasing debt-financed M&A activity in the BBB rated segment of the credit market, weaker covenant packages in the high-yield and bank loans space, questionable use of lines of credit (revolvers), and a growing preoccupation by management teams with shareholder returns.

However, we would note that there have been three credit cycle downturns in the past 30 years, and each was associated with either a sharp tightening in global financial conditions (precipitated by the bursting of a market bubble) or a protracted economic downturn during which time corporate default rates rose sharply. We do not see any near-term catalysts that could trigger such scenarios. Barring a full-blown trade war or a tail-risk event, we remain optimistic that the combined weight of resilient global growth, low inflation, central bank activism (resulting in interest rates remaining “low for longer”) and stable credit fundamentals should continue to extend the life of the global credit cycle for the foreseeable future.

A De-Escalation in Global Trade Tensions (For Now)

In a welcome development, the US and China reached an agreement on “phase one” of a trade deal. That stated, 18 months of brinksmanship and several rounds of tariff increases have already exacted a toll across a number of industries globally; more negotiations still lie ahead, which could impact business sentiment, investment and growth prospects.

The following illustration plots our Global Credit Team’s latest assessment of subsector (or industry) attractiveness versus sector vulnerability to trade war risk. In short, we see the best relative value in financials (with an emphasis on the strongest US and European banks across the capital structure), energy (mainly higher-rated, US oil-directed E&P as well as pipeline and midstream credits) and basic industries, specifically metals & mining (e.g., copper-related credits). In the Global Corporate Credit Sector Views section, we provide an at-a-glance compilation of our key observations across the main corporate credit sectors, followed by high level commentary for each asset class.

Credit Sector Views

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets.

Investment-Grade Markets

We remain a better holder of risk going into year-end given continued accommodative central bank policies and prevalent negative yields around the world. Our focus continues to be on banking, energy and metals & mining; these are sectors where positive fundamental trends remain intact, which exhibit the least sensitivity to tariff-related risk and where we are likely to see further uplift from the ratings agencies. European investment-grade credit fundamentals remain solid in most sectors, with the exception of autos and retail. The technical backdrop is supportive, with negative government bond yields and the re-start of corporate bond purchases by the ECB fueling demand for credit. Valuations are compelling given the low rate backdrop but still look tight on an historical basis.

High-Yield Markets

Given the positive fundamental backdrop, strong technical picture and supportive central banks, US high-yield spreads continue to compress and are broadly approaching fair value. We remain cautious on the lower quality segment of the market (e.g., CCCs) due to concerns over global growth, geopolitical tensions, election risk and late cycle access to capital availability. In Europe, a weaker economic backdrop is beginning to impact fundamentals. Technicals remain supportive given negative rates; however, valuations are less compelling. Primary issuance is mainly focused on refinancing and BB/B rated deals. We expect this trend to continue, resulting in less CCC issuance.

Bank Loan Markets

CLO formation will continue to be the primary driver for the loan asset class, resulting in a strong bid for higher quality names. Rates stability should drive retail flows to the asset class. Loans currently offer attractive carry with market value upside driven by ramping CLO vehicles. High-yield crossover and multi-asset credit accounts have been increasing allocations to loans due to the relative attractiveness, which has helped to drive single-B prices higher. Secondary levels have already begun to rally in December as investors with high cash balances look at a light 1Q20 supply calendar.

CLO Markets

BBB/BB CLOs still screen cheap relative to bank loans and high-yield while AAA/AA CLOs appear attractive relative to other comparably rated products. We expect CLO supply technicals to remain robust, which should continue to keep AAA spreads range-bound. BBB/BB spreads will take their cues from macro and high-yield/bank loan price movement. We believe there will be more tiering of prices in lower rated CLOs in the secondary versus primary markets, which will create opportunities. We still prefer front end AAAs and favor a slight barbell against longer spread duration new issue AAAs with price convexity. Within lower mezzanine tranches, opportunities exist in the secondary market.

Emerging Markets

EM financial conditions and flows continue to benefit from Fed dovishness and benign global conditions. Select investment-grade-rated EM sovereigns remain attractive from a carry standpoint, while BBB rated sovereigns appear more fully valued. Local rates, especially in Indonesia, Brazil and Russia, are also attractive given high real yields and a more dovish outlook from EM central banks. EM investment-grade corporates are an attractive complement to investment-grade allocations given higher spreads, shorter duration and more favorable technicals. For high-yield corporates, we have a preference for BBs in less financing-sensitive sovereigns and those generating revenues in hard currency.

Structured Credit Markets

We are constructive on housing fundamentals and expect modest home price growth over the coming years. Credit underwriting standards are historically high, making the quality of new loan production strong. We remain positive on the credit risk of GSEs (Fannie Mae and Freddie Mac) and recently issued non-agency loans as well as re-performing loans and securities. We also remain constructive on the CMBS market, due to broadly positive commercial real estate fundamentals and a favorable economic outlook. Here, we are positive on short-duration, well-structured single-borrower securitizations and loans; in conduit deals we see better value in AAA rated bonds.

Oil Markets: Geopolitical Risk Once Again on the Rise
Oil Icon

The recent flare up in Middle East hostilities—first, a targeted US air strike against a senior Iranian military officer followed by a retaliatory response by Iran with warnings of serious reprisal in the event of further US provocation—has priced new risk premiums into global oil markets. In contrast to oil price behavior following the series of drone strikes against Saudi processing facilities during 3Q19, this development has the potential to materially alter supply and demand fundamentals over the near term. Following these events, Brent and WTI spot prices were up 3.6% and 3.4%, respectively, but have since pulled back on more measured rhetoric between both sides. Longer-dated WTI prices were up less, 0.5%, and flat for 2021 and 2022 averages, respectively, as the market remains concerned about ample oil supplies, weakening longer-term demand and continued producer hedging of out-year production.

While there is a wide range of possible scenarios going forward, we believe WTI oil prices will remain elevated in the $60-$65 per barrel range to account for the additional geopolitical risk premiums. We would expect a more severe move higher in both short-dated and longer-dated crude should further hostilities materially impact regional supplies in Saudi Arabia or Iraq given the countries are the second and fifth largest oil producers in the world, respectively.

Prior to this development, the crude market in 2020 was shaping up to be relatively balanced—resilient oil demand growth, moderating US production growth, announced additional OPEC production cuts and continued geopolitical risks all supportive of oil prices. Concerns over trade tensions and weaker economic growth have since subsided on the back of the “phase one” US/China agreement and the signing of the US-Mexico-Canada Agreement (USMCA), which provide a more reasonable oil demand growth backdrop.

While WTI prices over the short term are expected to be elevated (and volatile) given the supply-side risks, we would expect prices to return to the $50-$55 per barrel range over the medium to longer term given lower demand growth from slowing forward economic activity. The rise in near-dated oil prices should enable US producers to extend hedge protections further into 2020 and 2021, providing a short-term boost to cash flows.

From a portfolio positioning perspective, our focus in the energy segment (investment-grade and high-yield) remains in the midstream where companies continue to benefit from more defensive characteristics including hard asset coverage and fee-based cash flow streams, which are not subject to direct commodity price risk. We remain less constructive on oil field services as exploration and production (E&P) companies have continued to focus on capital discipline and “operating within cash flow” resulting in lower drilling activity—the primary source of earnings. Where investment-grade and high-yield positioning differs slightly is in E&P. Investment-grade E&P offers the size, scale and diversification over high-yield counterparts. However, opportunities in high-yield are expected to present themselves this year, subject to improved terms and structure.

Credit Cycle Pulse
Baraometer

Much ink has been spilled over the past year on where we are in the global credit cycle and whether the party is about to end. Investor concern on this front is understandable, as credit spreads have ground tighter even while corporate sector leverage has crept higher, and as global growth has softened on the back of trade-related uncertainty. This is a potentially worrisome mix, many would argue. We also recognize that there are a number of signs in credit markets that warrant caution, for example: increasing debt-financed M&A activity in the BBB rated segment of the credit market, weaker covenant packages in the high-yield and bank loans space, questionable use of lines of credit (revolvers), and a growing preoccupation by management teams with shareholder returns.

However, we would note that there have been three credit cycle downturns in the past 30 years, and each was associated with either a sharp tightening in global financial conditions (precipitated by the bursting of a market bubble) or a protracted economic downturn during which time corporate default rates rose sharply. We do not see any near-term catalysts that could trigger such scenarios. Barring a full-blown trade war or a tail-risk event, we remain optimistic that the combined weight of resilient global growth, low inflation, central bank activism (resulting in interest rates remaining “low for longer”) and stable credit fundamentals should continue to extend the life of the global credit cycle for the foreseeable future.

A De-Escalation in Global Trade Tensions (For Now)
Sub Sectors Icon

In a welcome development, the US and China signed an agreement on “phase one” of a trade deal. That stated, 18 months of brinksmanship and several rounds of tariff increases have already exacted a toll across a number of industries globally; more negotiations still lie ahead, which could impact business sentiment, investment and growth prospects.

The following illustration plots our Global Credit Team’s latest assessment of subsector (or industry) attractiveness versus sector vulnerability to trade war risk. In short, we see the best relative value in financials (with an emphasis on the strongest US and European banks across the capital structure), energy (mainly higher-rated, US oil-directed E&P as well as pipeline and midstream credits) and basic industries, specifically metals & mining (e.g., copper-related credits). In the Global Corporate Credit Sector Views section, we provide an at-a-glance compilation of our key observations across the main corporate credit sectors, followed by high level commentary for each asset class.

Credit Sector Views
Sectors Icon

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets.

Investment-Grade Markets

We remain a better holder of risk going into year-end given continued accommodative central bank policies and prevalent negative yields around the world. Our focus continues to be on banking, energy and metals & mining; these are sectors where positive fundamental trends remain intact, which exhibit the least sensitivity to tariff-related risk and where we are likely to see further uplift from the ratings agencies. European investment-grade credit fundamentals remain solid in most sectors, with the exception of autos and retail. The technical backdrop is supportive, with negative government bond yields and the re-start of corporate bond purchases by the ECB fueling demand for credit. Valuations are compelling given the low rate backdrop but still look tight on an historical basis.

High-Yield Markets

Given the positive fundamental backdrop, strong technical picture and supportive central banks, US high-yield spreads continue to compress and are broadly approaching fair value. We remain cautious on the lower quality segment of the market (e.g., CCCs) due to concerns over global growth, geopolitical tensions, election risk and late cycle access to capital availability. In Europe, a weaker economic backdrop is beginning to impact fundamentals. Technicals remain supportive given negative rates; however, valuations are less compelling. Primary issuance is mainly focused on refinancing and BB/B rated deals. We expect this trend to continue, resulting in less CCC issuance.

Bank Loan Markets

CLO formation will continue to be the primary driver for the loan asset class, resulting in a strong bid for higher quality names. Rates stability should drive retail flows to the asset class. Loans currently offer attractive carry with market value upside driven by ramping CLO vehicles. High-yield crossover and multi-asset credit accounts have been increasing allocations to loans due to the relative attractiveness, which has helped to drive single-B prices higher. Secondary levels have already begun to rally in December as investors with high cash balances look at a light 1Q20 supply calendar.

CLO Markets

BBB/BB CLOs still screen cheap relative to bank loans and high-yield while AAA/AA CLOs appear attractive relative to other comparably rated products. We expect CLO supply technicals to remain robust, which should continue to keep AAA spreads range-bound. BBB/BB spreads will take their cues from macro and high-yield/bank loan price movement. We believe there will be more tiering of prices in lower rated CLOs in the secondary versus primary markets, which will create opportunities. We still prefer front end AAAs and favor a slight barbell against longer spread duration new issue AAAs with price convexity. Within lower mezzanine tranches, opportunities exist in the secondary market.

Emerging Markets

EM financial conditions and flows continue to benefit from Fed dovishness and benign global conditions. Select investment-grade-rated EM sovereigns remain attractive from a carry standpoint, while BBB rated sovereigns appear more fully valued. Local rates, especially in Indonesia, Brazil and Russia, are also attractive given high real yields and a more dovish outlook from EM central banks. EM investment-grade corporates are an attractive complement to investment-grade allocations given higher spreads, shorter duration and more favorable technicals. For high-yield corporates, we have a preference for BBs in less financing-sensitive sovereigns and those generating revenues in hard currency.

Structured Credit Markets

We are constructive on housing fundamentals and expect modest home price growth over the coming years. Credit underwriting standards are historically high, making the quality of new loan production strong. We remain positive on the credit risk of GSEs (Fannie Mae and Freddie Mac) and recently issued non-agency loans as well as re-performing loans and securities. We also remain constructive on the CMBS market, due to broadly positive commercial real estate fundamentals and a favorable economic outlook. Here, we are positive on short-duration, well-structured single-borrower securitizations and loans; in conduit deals we see better value in AAA rated bonds.

Currencies Bar Chart

Global Corporate Credit Sector Views

Banks
Trade War Risk
Baraomter Levels Low
Key Observations We remain constructive on the major banks in both the US and Europe given a relatively low-risk/resilient banking business model, conservative global bank regulation, and strong and stable fundamentals. The sector also continues to benefit from a resilient global economic backdrop supported by relatively stimulative central bank policies, benign technicals, conservative ratings with upward ratings pressure for US banks and banks’ generally bondholder-friendly strategies. US banks are particularly well positioned in a US environment of lower tax rates, moderate growth and friendlier domestic regulation. In a trade war scenario, the direct impact of tariffs would be negative for the sector overall, but the impact would likely be limited and manageable over the near term.
Chemicals
Trade War Risk
none
Key Observations Sector valuations are tight and not reflecting the cyclicality of the sector. On trade-related risk, this sector is a specific target of the Chinese retaliatory tariffs (mainly polyethylene). We assume tariffs would be passed down the supply chain and expect the main effect of tariffs to be a swapping of trade patterns; longer-term effects would be through indirect second round effects as trade patterns, prices and inventories adjust.
Energy
Trade War Risk
Baraomter Levels Low
Key Observations Our focus in the investment-grade and high-yield segments of the energy sector is midstream where companies continue to benefit from hard asset coverage and fee-based cash flow streams not subject to direct commodity price risk. We remain less constructive on oil field services as E&P companies have continued to focus on capital discipline resulting in lower drilling activity—the primary source of earnings. On trade-related risks, initially, what may be lost in terms of demand would be compensated for by the supply-side tension; second-order effects would be negative for the industry; US oil exports to China had been increasing over the past years given relative competitive pricing. An all-out trade war could upset the trend with cargoes likely displaced to another region; WTI discount to Brent would increase to facilitate the trade flow.
Metals & Mining
Trade War Risk
Baraomter Levels Low
Key Observations We remain focused on copper intensive names. Sentiment has overcome fundamentals; supply remains restrained and a tighter balance is the consequence. Distinction between metals is required. Longer term, second order effects would be negative; the remainder of the commodities complex has been adversely impacted from growing uncertainty over trade war effects and demand destruction which has manifested itself in lower prices. We continue to believe fundamentals remain intact (for now), albeit, demand has softened.
Pharmaceuticals
Trade War Risk
Baraomter Levels Low
Key Observations We are negative on pharmaceutical companies for drivers that are not associated with trade policy. Regulatory risks, negative event risks from M&A, constrained pricing flexibility and negative press from several bad actors will continue to weigh heavily upon the potential for credit quality improvement. The high-yield segment of the sector offers some value given the dispersion in the opportunity set.
Telecommunications & Media
Trade War Risk
Baraomter Levels Low
Key Observations We are selectively constructive on global telecom issuers. While pricing power continues to elude the sector, we note ongoing operator efforts around infrastructure asset sharing and cost reduction. Furthermore, a number of issuers made large debt-funded acquisitions, but are now in deleveraging mode. In media, disruption from the leading technology players is resulting in legacy content owners launching competing streaming services, free-to-air broadcasters experiencing viewership declines and advertising agencies having to reconfigure business models. As it relates to trade risk, the impact on telecommunications and media companies is somewhat limited as content owners do not generate much from China.
Utilities
Trade War Risk
Baraomter Levels Low
Key Observations Utilities is largely a domestic concern and primarily insulated from the impact of tariffs/trade wars; tariffs on industrial machinery may add to costs but are not considered material.
Aerospace &
Defense
Trade War Risk
Baraomter Levels Medium
Key Observations The sector has benefited from elevated geopolitical threats, but valuations remain unattractive. In Europe, Brexit is a bigger uncertainty given strong links between the UK and Europe's defense industry; companies could benefit from US-China tensions by capturing more orders and more market share in China versus Europe.
Gaming
Trade War Risk
Baraomter Levels Medium
Key Observations Most operators have geographically contained portfolios throughout the US, and as such would be limitedly impacted unless the skirmish ends up pushing unemployment levels higher. That said, there are several global operators that have significant exposure in Macau, and would likely feel a much larger impact, particularly in the event China implements protectionist measures, which we believe is a low probability but a tail risk nonetheless.
Retailing
Trade War Risk
Baraomter Levels Medium
Key Observations In the US, retailers lack sales growth opportunities and lack pricing power as a result of pricing transparency and convenience of online shopping. We retain our longstanding cautious stance and note ongoing structural headwinds such as discounters taking market share from traditional grocery retailers; growth of online sales channels in non-food retail are driving higher fulfillment costs, thereby negatively impacting profitability.
Agriculture
Trade War Risk
Baraomter Levels High
Key Observations Since March 2018, policy disputes between the US and China have diminished the sector’s outlook and this may extend into the foreseeable future. US-China trade disputes show China’s FY2018 imports of US agricultural products at $16 billion and forecast to decline to $7.3 billion in FY2019. The impact on our US agricultural trade surplus is significant with the current FY2019 US agricultural trade surplus projected to be the lowest since 2006. We do not see this trend reversing anytime soon given the current administration’s recent comments.
Auto & Related
Trade War Risk
Baraomter Levels High
Key Observations The global automotive sector remains under threat from both cyclical and secular forces. 2019 introduced a number of challenges, including: ongoing trade/tariff difficulties in Mexico and China, continued Brexit uncertainties and rising R&D costs associated with the movement toward Hybrid/EV platforms. While our fundamental view of the sector remains negative, we are cognizant that the relative value opportunity in the space provides attractive carry and total return potential in 2020, particularly if trade tensions between the US and China abate. Valuations in the investment-grade segment remain compelling; in high-yield, we continue to remain underweight.
Capital Goods
Trade War Risk
Baraomter Levels High
Key Observations The global manufacturing sector is in recession due to a sharp deterioration in manufacturing activity and global trade, with higher tariffs and prolonged trade policy uncertainty damaging investment and demand for capital goods. Chinese tariffs in general target aircraft and certain classes of SUVs, passenger cars and off-road vehicles. Agricultural tariffs and sensitivity to China construction/mining demand will continue to weigh on companies such as Caterpillar and Deere.
Consumer
Products &
Apparel
Trade War Risk
Baraomter Levels High
Key Observations Stronger earnings and the recent let-up in US-China trade tensions have helped brighten the outlook for the overall sector globally. In Europe, consumers appear relatively resilient and we have so far not seen material spill-over from weaker manufacturing/industrial activity. We would note that companies, in general, have proactively sourced away from China, re-engineered products to minimize or remove components on the tariff lists or increased prices starting in 2020. Management teams believe selective price increases will be easily absorbed by consumers without much pushback.
Food &
Beverage
Trade War Risk
Baraomter Levels High
Key Observations Results in the food & beverage sector are being pressured by input costs, as well as higher freight costs, but issuers have a very limited ability to pass along higher operating costs.
Technology
Trade War Risk
Baraomter Levels High
Key Observations The technology sector, especially in the US, remains heavily exposed to trade tensions given complex supply chains with significant Chinese exposure. In Europe, software players appear relatively insulated; hardware and semiconductor sectors are more exposed to “second degree” impact, e.g., Infineon, STM’s role in the European automobile supply chain
Transportation
Trade War Risk
Baraomter Levels High
Key Observations Transportation credits are fully valued with limited upside given the multiple headwinds that include volatile fuel costs, a rising labor shortage, the threat of new entrants or disruptive technology. Any new tariffs may accelerate the reevaluation of sourcing decisions that should lead to lower freight charges.
Sector Category Trade War Risk Key Observations
Banks Baraomter Levels Low We remain constructive on the major banks in both the US and Europe given a relatively low-risk/resilient banking business model, conservative global bank regulation, and strong and stable fundamentals. The sector also continues to benefit from a resilient global economic backdrop supported by relatively stimulative central bank policies, benign technicals, conservative ratings with upward ratings pressure for US banks and banks’ generally bondholder-friendly strategies. US banks are particularly well positioned in a US environment of lower tax rates, moderate growth and friendlier domestic regulation. In a trade war scenario, the direct impact of tariffs would be negative for the sector overall, but the impact would likely be limited and manageable over the near term.
Chemicals none Sector valuations are tight and not reflecting the cyclicality of the sector. On trade-related risk, this sector is a specific target of the Chinese retaliatory tariffs (mainly polyethylene). We assume tariffs would be passed down the supply chain and expect the main effect of tariffs to be a swapping of trade patterns; longer-term effects would be through indirect second round effects as trade patterns, prices and inventories adjust.
Energy Baraomter Levels Low Our focus in the investment-grade and high-yield segments of the energy sector is midstream where companies continue to benefit from hard asset coverage and fee-based cash flow streams not subject to direct commodity price risk. We remain less constructive on oil field services as E&P companies have continued to focus on capital discipline resulting in lower drilling activity—the primary source of earnings. On trade-related risks, initially, what may be lost in terms of demand would be compensated for by the supply-side tension; second-order effects would be negative for the industry; US oil exports to China had been increasing over the past years given relative competitive pricing. An all-out trade war could upset the trend with cargoes likely displaced to another region; WTI discount to Brent would increase to facilitate the trade flow.
Metals & Mining Baraomter Levels Low We remain focused on copper intensive names. Sentiment has overcome fundamentals; supply remains restrained and a tighter balance is the consequence. Distinction between metals is required. Longer term, second order effects would be negative; the remainder of the commodities complex has been adversely impacted from growing uncertainty over trade war effects and demand destruction which has manifested itself in lower prices. We continue to believe fundamentals remain intact (for now), albeit, demand has softened.
Pharmaceuticals Baraomter Levels Low We are negative on pharmaceutical companies for drivers that are not associated with trade policy. Regulatory risks, negative event risks from M&A, constrained pricing flexibility and negative press from several bad actors will continue to weigh heavily upon the potential for credit quality improvement. The high-yield segment of the sector offers some value given the dispersion in the opportunity set.
Telecommunications & Media Baraomter Levels Low We are selectively constructive on global telecom issuers. While pricing power continues to elude the sector, we note ongoing operator efforts around infrastructure asset sharing and cost reduction. Furthermore, a number of issuers made large debt-funded acquisitions, but are now in deleveraging mode. In media, disruption from the leading technology players is resulting in legacy content owners launching competing streaming services, free-to-air broadcasters experiencing viewership declines and advertising agencies having to reconfigure business models. As it relates to trade risk, the impact on telecommunications and media companies is somewhat limited as content owners do not generate much from China.
Utilities Baraomter Levels Low Utilities is largely a domestic concern and primarily insulated from the impact of tariffs/trade wars; tariffs on industrial machinery may add to costs but are not considered material.
Aerospace &
Defense
Baraomter Levels Medium The sector has benefited from elevated geopolitical threats, but valuations remain unattractive. In Europe, Brexit is a bigger uncertainty given strong links between the UK and Europe's defense industry; companies could benefit from US-China tensions by capturing more orders and more market share in China versus Europe.
Gaming Baraomter Levels Medium Most operators have geographically contained portfolios throughout the US, and as such would be limitedly impacted unless the skirmish ends up pushing unemployment levels higher. That said, there are several global operators that have significant exposure in Macau, and would likely feel a much larger impact, particularly in the event China implements protectionist measures, which we believe is a low probability but a tail risk nonetheless.
Retailing Baraomter Levels Medium In the US, retailers lack sales growth opportunities and lack pricing power as a result of pricing transparency and convenience of online shopping. We retain our longstanding cautious stance and note ongoing structural headwinds such as discounters taking market share from traditional grocery retailers; growth of online sales channels in non-food retail are driving higher fulfillment costs, thereby negatively impacting profitability.
Agriculture Baraomter Levels High Since March 2018, policy disputes between the US and China have diminished the sector’s outlook and this may extend into the foreseeable future. US-China trade disputes show China’s FY2018 imports of US agricultural products at $16 billion and forecast to decline to $7.3 billion in FY2019. The impact on our US agricultural trade surplus is significant with the current FY2019 US agricultural trade surplus projected to be the lowest since 2006. We do not see this trend reversing anytime soon given the current administration’s recent comments.
Auto & Related Baraomter Levels High The global automotive sector remains under threat from both cyclical and secular forces. 2019 introduced a number of challenges, including: ongoing trade/tariff difficulties in Mexico and China, continued Brexit uncertainties and rising R&D costs associated with the movement toward Hybrid/EV platforms. While our fundamental view of the sector remains negative, we are cognizant that the relative value opportunity in the space provides attractive carry and total return potential in 2020, particularly if trade tensions between the US and China abate. Valuations in the investment-grade segment remain compelling; in high-yield, we continue to remain underweight.
Capital Goods Baraomter Levels High The global manufacturing sector is in recession due to a sharp deterioration in manufacturing activity and global trade, with higher tariffs and prolonged trade policy uncertainty damaging investment and demand for capital goods. Chinese tariffs in general target aircraft and certain classes of SUVs, passenger cars and off-road vehicles. Agricultural tariffs and sensitivity to China construction/mining demand will continue to weigh on companies such as Caterpillar and Deere.
Consumer
Products &
Apparel
Baraomter Levels High Stronger earnings and the recent let-up in US-China trade tensions have helped brighten the outlook for the overall sector globally. In Europe, consumers appear relatively resilient and we have so far not seen material spill-over from weaker manufacturing/industrial activity. We would note that companies, in general, have proactively sourced away from China, re-engineered products to minimize or remove components on the tariff lists or increased prices starting in 2020. Management teams believe selective price increases will be easily absorbed by consumers without much pushback.
Food &
Beverage
Baraomter Levels High Results in the food & beverage sector are being pressured by input costs, as well as higher freight costs, but issuers have a very limited ability to pass along higher operating costs.
Technology Baraomter Levels High The technology sector, especially in the US, remains heavily exposed to trade tensions given complex supply chains with significant Chinese exposure. In Europe, software players appear relatively insulated; hardware and semiconductor sectors are more exposed to “second degree” impact, e.g., Infineon, STM’s role in the European automobile supply chain
Transportation Baraomter Levels High Transportation credits are fully valued with limited upside given the multiple headwinds that include volatile fuel costs, a rising labor shortage, the threat of new entrants or disruptive technology. Any new tariffs may accelerate the reevaluation of sourcing decisions that should lead to lower freight charges.