- MAC portfolio positioning—along with our conviction that the combined weight of sturdy global growth, low inflation, accommodative central banks and low interest rates should continue to extend the life of the current credit cycle—has been key to its positive performance.
- Our focus remains on those subsectors within the high-yield and investment-grade markets, which we believe offer the best relative value and exhibit a lower sensitivity to tariffs.
- More accommodative monetary policy by the Fed could disproportionately benefit the rest of the world more than the US, which is why we have maintained a healthy (and well-diversified) allocation to EM.
- Despite alarmist headlines on the state of the leveraged loan market, we continue to see attractive underlying fundamentals and expect moderate growth in the coming quarters for corporates.
- Structured credit remains a key allocation in MAC portfolios, supported in large part by the continuation of the deleveraging trend observed in consumer and household debt.
- Our base case with respect to global trade war risk is that all sides will pull back before we reach a critical point, and that central banks stand ready with additional accommodative policy should the need arise.
Spreads across global fixed-income markets have compressed markedly since the highs of 4Q18. However, the path has been much more erratic since then with markets either rallying on signs of another dovish pivot by a major central bank—the Federal Reserve (Fed) and European Central Bank (ECB) being the most recent examples—or selling off on fears that the trade spat between the US and China might be broadening and expanding onto new fronts, for example Mexico and Europe. Despite seesawing markets, MAC performance has remained resilient with the composite up 6.73% (gross of fees) through May 2019. Portfolio positioning, both in terms of spread risk exposure and overall portfolio duration, has been key to this performance result as well as our conviction that the combined weight of sturdy global growth, low inflation, accommodative central banks and low interest rates should continue to extend the life of the current credit cycle.
Looking ahead, we believe MAC portfolios are well positioned to capture any upside that might come from receding trade war risk or a now-likely Fed rate cut intended to support US growth momentum. Indeed, in the latest Federal Open Market Committee (FOMC) meeting, Fed Chair Jerome Powell communicated a clear path for cutting rates this year, and even leaned into a cut at the July meeting as a strong possibility. The market responded accordingly, with US Treasury (UST) bonds rallying, credit markets tightening and the US dollar weakening.
In general, more accommodative monetary policy by the Fed should be supportive of spread product. It could also disproportionately benefit the rest of the world, which is why we have maintained a healthy (and well-diversified) allocation to emerging markets (EM). Finally, more accommodative policy could also lead to lower UST rates, although the effect there has been less clear to us given that a lot has already been priced and good risk asset performance limits the flight-to-quality bid for USTs. Should US rates creep higher on the back of a surprise US-China breakthrough or negotiated détente around the timing of the G-20 meeting in Tokyo at the end of June, we would look to add to duration in MAC portfolios as we believe it remains the best diversifying hedge against unforeseen risks.
At present, MAC portfolios hold a 25% allocation to high-yield (HY) corporate credit and a 10% allocation to investment-grade (IG) corporate credit. While portfolios have benefited from the sharp retracement in US and European credit spreads since late 4Q18, we believe fundamentals and technicals warrant no major changes in corporate credit positioning. In a recent whitepaper, Trade Wars in the 21st Century: More Perspectives From the Frontline, we presented our broad assessment of trade war vulnerability across all of the major sectors (see Table 1 in Appendix). Our focus remains on those subsectors within the HY and IG markets that we believe offer the best relative value and, more importantly, that exhibit a lower sensitivity to tariffs: financials (with an emphasis on the strongest US and European banks across the capital structure), energy (mainly US oil-directed E&P as well as pipeline and midstream credits) and basic industries, specifically metals and mining (e.g., copper-related credits). Our emphasis is also on higher quality issuers such as “rising stars,” which are BB rated credits that have the potential to move up to IG over the next 12-18 months.
Spreads across HY and IG credit markets have widened as of late due to a number of market concerns (e.g., trade tensions, Brexit, Italy, Iran), but as Western Asset CIO Ken Leech noted in his 2Q19 Market Commentary, “the world of yield starvation is coming very much back into play.” The stock of negative-yielding debt globally now stands at a record high of $13 trillion. Interest rates of 2%+ in the US are high by comparison and yield spreads across credit markets are also the most generous. We believe these data points along with the Fed’s explicit commitment to “act as appropriate to sustain the [US] expansion” support the case for having a healthy allocation to corporate credit.
On the margin—and keeping in mind that markets may become more volatile in the coming months—we have been incrementally reducing some HY holdings that have run their course and adding to bank loans where we currently hold a ~10% allocation. Despite alarmist headlines on the state of the leveraged loan market, we continue to see attractive underlying fundamentals and expect moderate growth in the coming quarters for corporates. Growth in collateralized loan obligations (CLO) demand over the near-term should continue to drive market technicals, as these vehicles represent around 70% of the loan buyer base. From a risk-reward standpoint, we find the first lien status, attractive carry relative to HY and reduced price volatility of bank loans (particularly in the $500 million to $2 billion segment of the loan market) to be a good fit for MAC portfolios. We have also been adding exposure to CLOs with an emphasis on the highest quality (AAA rated) tranches given their history of resilience during periods of severe market dislocation and compelling carry profile relative to other credit markets, such as similarly rated IG corporate credit and commercial mortgage backed securities (CMBS).
Structured credit remains a key allocation in MAC portfolios (~16% weight) supported in large part by the continuation of the deleveraging trend observed in consumer and household debt and the lower correlation that non-agency residential MBS (NARMBS) and CMBS have to corporate credit. In the NARMBS space, we remain constructive on housing fundamentals and expect modest home price growth over the coming years, with limited downside risks as housing appears reasonably valued and supported. Credit underwriting standards are historically high, making the quality of new loan production strong. We also remain constructive on the CMBS market due to broadly positive commercial real estate fundamentals and a supportive economic backdrop; however, we expect the fundamental outlook to be uneven across property types and markets. At present, we have a favorable view of valuations in Fannie Mae/Freddie Mac credit risk transfer (CRT) deals in the NARMBS space and mezzanine-level, single asset/single borrower securitizations in the CMBS space. We also have an allocation to ABS that reflects our constructive view of off-the-run, high quality sectors such as student loans, rental cars and auto floor plans.
Rounding out the sector line-up is EM. Despite uncertainty about global growth conditions and trade tensions, in our opinion EM fundamentals, in aggregate, remain on solid footing and recent dovish pivots by central banks across developed markets (DM) and EM bode well for EM financial conditions and flows. We currently see good value in USD-denominated sovereign and corporate credit. While EM local markets offer high real yields relative to DM countries, we have been very selective in this space due to the potential for EM currencies to weaken versus the US dollar should trade tensions escalate further. At present, we have an allocation of ~9% in USD-denominated sovereign debt (reflecting our participation across various new issues such as Qatar, Ghana and Ecuador), ~7% in USD-denominated corporate debt (mainly commodity-related issuers which offer a spread advantage over their sovereign debt), and ~7% in local currency denominated debt (with an emphasis on Indonesia, Mexico, Brazil and Russia, which currently offer high real yields relative to DM countries).
Based on the most recent headlines, the potential impact on markets of a full-blown trade war has become increasingly binary: on one hand, any surprise breakthrough or a negotiated détente on US-China trade talks would result in a sustained tailwind for spread sectors as we move into year-end. On the other, should the US move ahead and place tariffs on remaining imports from China and then open new fronts in the global trade war, it is not unreasonable to expect a stronger US dollar in the short term (which would roil EM countries), materially wider spreads across credit markets and lower DM bond yields, as markets price in the prospect of weaker growth and inflation as well as more policy accommodation by the major central banks. Our base case is that all sides will pull back before we reach such a critical point and that central banks—led by the Fed and ECB—will stand ready to unleash more expansionary measures should the need arise.
View the Appendix.
View the important Performance and Risk Disclosures for Multi-Asset Credit.