First Quarter 2020 INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE 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 mo- mentum. 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 sen- timent, 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. Welcome to the inaugural issue of Western Asset’s Global Credit Monitor, a publication that provides fixed-income investors with our holistic assessments of trends, technicals and relative value across the entirety of the global credit market.
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First Quarter 2020
INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
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 mo-mentum. 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 sen-timent, 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.
Welcome to the inaugural issue of Western Asset’s Global Credit Monitor, a publication that provides fixed-income investors with our holistic assessments of trends, technicals and relative value across the entirety of the global credit market.
Western Asset First Quarter 2020
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, re-spectively, 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 pro-ducers 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 contin-ued 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, oppor-tunities in high-yield are expected to present themselves this year, subject to improved terms and structure.
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-re-lated 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
Oil Markets: Geopolitical Risk Once Again on the Rise
Credit Cycle Pulse
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Relative Sector Attractiveness in Relation to Trade War Risk
continued from Credit Cycle Pulse 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.
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) attractive-ness 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.
A De-Escalation in Global Trade Tensions (For Now)
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Credit Sector Views Investment-Grade MarketsWe 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-re-lated 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 sup-portive, 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 MarketsGiven 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 MarketsCLO 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 MarketsBBB/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 MarketsEM 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 tech-nicals. For high-yield corporates, we have a preference for BBs in less financing-sensitive sovereigns and those generating revenues in hard currency.
Structured Credit MarketsWe 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.
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.
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Global Corporate Credit Sector Views
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Sector Category Trade War Risk Key Observations
BanksLow
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 contin-ues 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 bondhold-er-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.
ChemicalsLow
Sector valuations are tight and not reflecting the cyclicality of the sector. On trade-related risk, this sector is a spe-cific 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.
EnergyLow
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 dis-cipline 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 & MiningLow
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 ef-fects 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 contin-ue to believe fundamentals remain intact (for now), albeit, demand has softened.
PharmaceuticalsLow
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.
Telecommunica-tions & Media 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.
UtilitiesLow
Utilities is largely a domestic concern and primarily insulated from the impact of tariffs/trade wars; tariffs on indus-trial machinery may add to costs but are not considered material.
Aerospace &Defense 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.
GamingMedium
Most operators have geographically contained portfolios throughout the US, and as such would be limitedly im-pacted unless the skirmish ends up pushing unemployment levels higher. That said, there are several global oper-ators 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.
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Sector Category Trade War Risk Key Observations
RetailingMedium
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 head-winds 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.
AgricultureHigh
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 prod-ucts 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 & RelatedHigh
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/Electric Vehicle 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 GoodsHigh
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 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 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.
TechnologyHigh
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 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.
Global Corporate Credit Sector Views continued from previous page
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DefinitionsThe Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Organization of Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization of 12 oil-exporting developing nations that coordinates and unifies the petroleum policies of its member countries.
“Brexit” is a shorthand term referring to the UK vote to exit the European Union.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
Developed markets (DM) refers to countries that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets.
Brent Crude Oil is a major trading classification of sweet light crude oil that serves as a major benchmark price for purchases of oil worldwide.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. It is the underlying commodity of Chicago Mercantile Exchange’s oil futures contracts.
Investment-grade bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
A BBB rating is the lowest investment-grade rating; it reflects an opinion that the issuer has the current capacity to meet its debt obligations but faces more solvency risk than A-, AA- or AAA-rated issues.
A CCC rating is assigned to fairly speculative debt instruments; indicates the issuer is at greater risk of default than a B-rated issue and less than a CC-rated issue if business, financial, or economic conditions change measurably.
High yield, or below-investment grade bonds are those with a credit quality rating of BB or below.
The Agreement between the United States of America, the United Mexican States, and Canada is a free trade agreement between Canada, Mexico, and the United States. It is referred to differently by each signatory—in the United States, it is called the United States–Mexico–Canada Agreement (USMCA); in Canada, it is officially known as the Canada–United States–Mexico Agreement (CUSMA) in English and the Accord Canada–États-Unis–Mexique (ACEUM) in French; and in Mexico, it is called the Tratado entre México, Estados Unidos y Canadá (T-MEC). The agreement is sometimes referred to as “New NAFTA”I n reference to the previous trilateral agreement it is meant to supersede, the North American Free Trade Agreement (NAFTA).
E&P (exploration and production, or E&P) is a specific sector within the oil and gas industry, focused on finding, augmenting, producing and merchandising different types of oil and gas.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
Mergers and acquisitions (M&A) is a general term used to refer to the consolidation of companies. A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed.
Revolving credit, or revolvers, refers to a line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed. It is usually used for operating purposes, fluctuating each month depending on the customer’s current cash flow needs.
The terms upstream, midstream and downstream refer to the flow or commercial movement of oil, natural gas, natural gas liquids, refined petroleum, coal and other energy-related natural resources from producing wells (upstream) through storage and transportation (midstream) to end-users (downstream).
A collateralized loan obligations (CLO) is a security backed by a pool of debt, often low-rated corporate loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, and it dictates who will be paid out first when the underlying loan payments are made.
Spread duration is the sensitivity of the price of a bond to a 100 basis point change to its option-adjusted spread.
Mezzanine financing is a hybrid of debt and equity financing that is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full.
Carry refers to a differential in interest rates across sectors, such that tactical profits could be generated by trading between them.
Convexity is a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed. As convexity increases, the systemic risk to which the portfolio is exposed increases. As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor.
Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed-income investment will be to interest rate changes.
Structured credit investments include collateralized bond obligations (CBOs), collateralized debt obligations (CDOs), syndicated loans and synthetic financial instruments. A CBO is understood to be of investment grade, but is backed with the use of a pool of below-investment-grade bonds. CDOs are a kind of asset-backed security, holding a pool of collateralized debt, such as mortgages and auto loans, that may be subdivided into various tranches representing different levels of risk. A syndicated loan is a loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower. Synthetic financial instruments are artificially created investment vehicles or instruments intended to meet requirements not met by existing, conventional instruments. They are designed to reduce risk, increase diversification or offer a higher return. A synthetic floating rate instrument can be produced by combining a fixed-rate bond and an interest rate swap. Or an asset with the same risks and rewards as the underlying share can be created by the purchase of a call option and the simultaneous sale of a put option on the same share.
Government-sponsored enterprise (GSE) includes the Federal Home Loan Mortgage Corp (FHLMC), also known as Freddie Mac; and the Federal National Mortgage Association (FNMA), also known as Fannie Mae. GSEs were chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
