• Q2 saw nice returns from riskier assets
• Credit impulse key to global growth
• 'Caution needed towards EM exposure'
By Simon Fasdal
Summer has arrived, and warmer and stable winds have reached the Nordic region. Stability is also the hallmark of developments in the second quarter when we look at financial markets. Despite a few blips on the VIX screen, a very stable environment has surrounded fixed income overall and also helped to extend the equities rally deep into the second quarter.
Our major topics for the second quarter were the election risk factors, which we believed were exaggerated, and the failure of global yields to move higher. The sideways yield environment was something we feared could persist due to lower oil prices and geopolitical tail risk.
Major components of this Q2 scenario did materialise and have brought nice returns to riskier asset classes due to low volatility and continued sideways global yields and inflation. Despite lower yields in the latter part of Q2 and global macroeconomic conditions going from hot to lukewarm, there are apparently no concerns to trace when looking at equities and credit spreads worldwide.
Viewed from this positive backdrop entering the third quarter, one could be tempted to extrapolate a positive development in riskier assets – that is, global equities, high-yield, and emerging-market bonds. Indeed, there are still positive signs: Europe seems to be in better condition than it has been for the last five years and many political and geopolitical risk triggers — such as European elections, Trump's impact on global trading, and the East-West and Middle Eastern crises, just to mention a few — are at the moment playing very minor roles or have lost significance.
From that perspective, we could see yet another quarter with stable income in the riskier bond classes. However, other risk triggers have emerged and are drawing uncomfortably close.
As mentioned by Peter Garnry and Steen Jakobsen, we are concerned about the slowdown in the global credit impulse and the possibility that it could trigger a global economic slowdown. Since the financial crisis, the global economy has largely been fuelled by credit.
We are especially concerned about the lack of credit impulse in China and the fact that markets seem to ignore that 35% of global growth is derived from China. The lack of credit impulse is also visible in the US. The third quarter could see additional unpleasant surprises enter the macro picture, which would impact equity and bond markets.
The impact on equity markets if we see a global slowdown scenario unfold in Q3 is one thing; another would be the effect on global fixed income.
In such a scenario, there are three major factors to watch.
Price of credit
The most direct impact of a lower global credit impulse would be that the global price of credit would increase. One credit unit would simply be more expensive and investors in bonds would demand a higher spread, which would bring higher credit spreads. This would mean, all other things being equal, higher yields and lower prices on higher-yielding, riskier bond classes.
A potential lack of growth in China would of course be painful, but in fixed-income terms the major concern is related to the price slump in commodities potentially caused by such a slowdown. If a growth slowdown becomes reality, we would expect significant price drops in energy and metals prices that would lead to severe problems for corporates and countries dependent on oil and iron ore.
Brazil, which recently has been challenged by political turmoil, could face a significant drag on its economy if prices and demand from China fall. As much as 55% of Brazilian iron ore exports go to China, and the Brazil-China iron ore connection is a vital part of the Brazilian economy.
Furthermore, the connection faces fierce competition from Australia. A potential slowdown in China would therefore trigger caution towards Latin American bonds, especially Brazilian bonds. It would also weigh on corporates linked to exports of iron ore as well as energy-related corporates, which Brazil is heavily dependent on as well.
Russia is now China’s top oil supplier, and the relationship has seen tremendous growth rates over the last couple of years, up 24% in 2016. Russia has done a nice job fighting the aftermath of the huge oil drop shock in early 2016, which resulted in a very weak rouble and a selloff in Russian assets. Since then we have seen a major rally in Russian assets, Eurobonds in particular.
With a potential slowdown in Chinese growth and a drop in demand and prices for oil, Russia would once again face challenges due to its dependence on energy exports. This could force budget cuts and harm growth estimates. Furthermore, corporates involved in or closely related to the energy sector could lose vital revenue and face deteriorating credit quality.
Could the Russian economy freeze over on broad oil declines? Photo: Shutterstock
We think that the resilience shown by the Russian economy in the past two years provides evidence that the country is able to cope with such external shocks. However, the presently very contracted credit spreads for energy and Russian Eurobonds should cause investors to be cautious in Q3.
The inflation that disappeared
The scenario of an economic slowdown and lack of credit impulse should draw attention to the current positive developments in corporate bonds and emerging-market assets. As we speak, the European high-yield corporate bond CDS spread iTraxx XOVER is hovering at a three-year low of 235. The same goes for the JP Morgan emerging-market EMBI spread, which is back to its 2014 levels.
We have been very positive on EM bonds and the credit environment as a whole, and also believe the developments have been justified.
However, if a slowdown starts to occur, it would be an unfortunate combination to see very contracted credit spreads face the reality of lower global growth and lower commodity prices. Caution is needed especially towards EM bond exposure, as challenges related to credit quality, the lack of credit impulse, and the overall uncertainty of EM countries’ ability to cope with external shocks could lead to a sudden credit crunch, sending currencies and assets into turbulence and potentially stoking fears of market illiquidity that could activate fund selling.
Light at the end of the tunnel
Having said all that, the picture is not entirely negative for bond markets in the third quarter. A global slowdown and an expected slump in commodity prices would send core yields south again. Remember that one of the biggest fears for the bond market was the fear of higher US yields, where a 3% 10-year yield was seen as the tipping point that could send global bond markets into cataclysmic selling.
Instead, with lower growth, slumping commodity prices and falling inflation expectations, we could easily face a return to levels below 2% for the US 10-year, and see significant gains in longer-maturity investment-grade bonds outside the scope of commodity-dependent corporates and countries.
— Edited by Michael McKenna
Simon Fasdal is head of fixed income trading at Saxo Bank