Global Weekly: Still waiting for Santa Claus

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A ‘Santa Claus’ rally should have been triggered this week by the comments from US Federal Reserve Chairman Jerome Powell hinting at possibly approaching the end of the US central bank’s rate-hiking cycle and the agreement by US and Chinese presidents Trump and Xi Jinping to suspend further tariffs increases for 90 days.

These two elements – the Fed’s rate hikes and the trade dispute -- were the main headwinds to the markets this year. But this rally might take time to materialize. Investor enthusiasm faded after mixed statements from White House officials, including several presidential tweets, cast doubt on the solidity of the trade deal. As a consequence, global markets suffered one of the biggest sell-offs in recent months, stirred by worries on global growth.

Despite recent data showing continued solid US growth, the spill-over effect of trade wars on the global economy is starting to be felt. Growth for the Swiss and Swedish economies, both export-oriented economies, registered a surprising contraction in the third quarter. Moreover, Asian manufacturing data continued to weaken. Cyclical economies, such as South Korea and Taiwan, were particularly hard hit, as levels moved below 50, indicating contraction.

Earnings momentum has continued to deteriorate. The US saw the biggest declines since October, with next-year earnings growth expectations falling to 8.7% from 10.6%. Asia Pacific (including Japan) and emerging markets experienced a similar trend. Surprisingly, European earnings growth expectations remain unchanged -- so far.

The Brexit saga is continuing, as the debate heats up ahead of the full vote next week. Prime Minister Theresa May has suffered a series of defeats: her government was accused of “contempt of Parliament” for not having disclosed publicly the legal advice it received on the Brexit text and for not allowing parliament to have more say if the proposed Brexit deal were to be rejected. Moreover, the latest position from the advocate of the Court of Justice of the EU that the UK could unilaterally decide to stay within Europe could induce more uncertainty regarding the exit outcome.

In this volatile environment, we continue to favour stocks over bonds, as political risks could abate in the coming months.

Some facts about corporate bonds

Corporate bond risk premiums have risen north of 150 basis points. Before we ascertain whether this is a good entry point, here are some considerations. It is often said that over the long run, corporate bonds generate some 120 basis points additional yield compared with safe government bonds. Over the last 20 years or so, the average credit spread of the entire European investment-grade (IG) corporate bond universe has been exactly that. Two questions come to mind: Does that mean that investors have earned these 120 basis points? And, is a comparison of corporate bonds from, say, ten years ago, with today, an ‘apples to apples’' comparison? The answer is no.

The entire IG corporate bond universe has generated an average excess return to safe government bonds of only 40 basis points annually. Where did the missing 80 basis points go?

Some 35 basis points is lost due to the crossover effect. Bonds of companies that are downgraded to non-investment grade, also known as ‘fallen angels’, are only taken out of the index at the end of the month. A lot of money that is professionally managed is not allowed to hold non-investment grade bonds. So once a company is downgraded to non-investment grade, these investors have to sell those bonds, which negatively affects the index return. The effect is immense.

But most of the fallen angels tend to pay off their debt. The investors selling them therefore throw a juicy bone towards high-yield investors. The remaining return drag is associated with credit-rating agencies. Over the long run, the rating agencies typically announce more downgrades than upgrades. Moreover, investors tend to punish downgrades more than they appreciate upgrades.

The effect of downwards sliding credit quality over the long run is also the reason why index spreads today cannot be compared with the spreads of ten years ago. Although it is true if you compare the credit quality of today’s corporate bond index with, say, the pre-2008 credit quality, it has significantly deteriorated. Today, 50% is rated BBB, whereas this was only 19% in December 2007.

If this continues, will we have a host of new fallen angels in the future? Well, it depends on how the index quality evolves. In the past two years, rating agencies have been upgrading more than downgrading. In addition, the largest segment of BBB-bonds are still rated BBB+. This means they are further away from crossing over into non-investment grade.

It can also be expected that if we would hit recessionary territory, which we do not expect, in such an environment, all corporate bonds would be hurt.