NN IP: We upgrade US high yield as we expect oil prices to bottom

Strong performance of spread products

Performance of spread products so far this year has been strong, aided by a not too hot, neither too cold global economic recovery. The fading of the reflation theme over the year, provoked by the levelling off of global macroeconomic surprises since March, the renewed decline in commodity and oil prices in particular, and the decreased likelihood of US fiscal policy easing has kept the search for yield and carry alive. Inflation and inflation expectations in the US and Eurozone surprised to the downside, allowing central banks to remain accommodative in their policies, further supporting spread categories at large.

While spread performance so far this year has been good across the board, some divergences are visible between categories. Within EMD, local currency (LC) so far stood out as spreads tightened more than hard currency (HC) spreads, both sovereign and corporates. The resilience in Chinese economic growth, constructive EM macro data and accommodative DM central banks catered for continued investor inflows into EMD. So far this year, EMD attracted an estimated over +10% of AuM in inflows, outpacing inflows of +7% seen over the entire last year. Latin America was the region of choice in this respect. At the same time undershoots in EM inflation allowed main EM central banks to ease monetary policy, supporting EMD LC relatively more.

Other than the outperformance of EMD LC year-to-date has been the outperformance of EUR credit paper versus USD credit paper in terms of spread tightening. This holds for both Investment Grade and High Yield (see Figure 1) with EUR paper outperforming. Eurozone peripheral government bonds saw their spreads tighten as well, albeit to a lesser extent. The underperformance of the latter occurred despite some progress in the Italian banks’ non-performing loan clean-up, as well as the decreased likelihood of snap elections as a new electoral law is still being debated.

The outperformance of EUR credits started in mid-April, both in IG as well as in HY. Things that have been influential in this respect were the improvement in relative macroeconomic surprises in the Eurozone versus the US, a strong European corporate earnings pattern and the removal of a political tail risk with the French presidential elections. Probably also at play has been the slower (expected) path of monetary policy normalization in the Eurozone compared to the US. Finally, the renewed decline in oil and commodity prices weighed relatively more on USD credit.

We now prefer US high yield to EUR high yield

At the end of June we neutralized our HY positions (EUR HY from overweight and US HY from underweight), keeping Global HY at neutral currently. Early July we upgraded US HY further to overweight to the detriment of EUR HY going underweight. (EUR) IG is still preferred over HY.

EUR HY has outperformed USD HY on better relative economic surprises and earnings and on lower oil and commodity prices which affected USD HY more. More recently, indicators turned more favourable for US HY again. We expect oil prices to bottom out, with a likely oil market rebalancing starting in Q3. US equity momentum has also improved recently. Meanwhile, indicators for EUR HY have deteriorated somewhat. Longer-term economic surprises in the Eurozone have levelled off. Also, more corporate-specific factors for EUR HY like corporate surprises, earnings momentum and leverage have weakened somewhat, as well as sentiment indicators. Uncertainty about ECB monetary policy normalization may also weigh on the EUR HY category.

While the weakness in commodity and oil prices has weighed on US HY relatively more than on EUR HY, US HY has nevertheless been less vulnerable in this respect than in the past. US HY spread correlation this year is -0.16 and -0.20 versus the Bloomberg Commodities Index and WTI crude oil respectively. This is clearly below the -0.49 and -0.58 correlations resp. over the last three years. Also, US HY energy spreads indicate far less stressed levels than in early 2016 at the oil price lows (see Figure 2). Moreover, as said, we expect oil prices to bottom out from here.

Within EMD finally, we raised the overweight in EMD LC rates to medium (from small). EM flows and sentiment indicators are supportive, while relative EM economic surprises versus DM have improved again recently. Meanwhile, potential for EM monetary policy easing remains intact.