NN IP: Strong year for spread products

As we approach the end of the year, some reflection over the past year and an outlook on the way forward are custom in financial markets. For spread markets, 2017 turned out to be another strong year. Both credit yields and spreads tightened further, providing carry and capital gains. At the same time, an improving macroeconomic backdrop since the summer and the expectation that central banks, faced with subdued inflation, would remain gradual in their policy normalization kept default rates low and corporate fundamentals solid.

This is not to say that 2017 was a smooth ride for spread markets. Intermittent periods of stress and spread widening occurred, which were systematically countered by the dominant forces of macro and the central bank policy outlook. As such, the most recent spread widening we saw in the first half of November turned out to be another wobble. In a sense, it resembled earlier periods of tension in spread markets in 2017 like the one in the run-up to the French presidential election in March-April or the one with the rise in geopolitical tension around North Korea in August.

As credit spreads tightened further, valuation of spread products – which was already a concern at the start of the year – became more stretched from a historical perspective. This begs the question whether a valuation reset is approaching and whether it caters for an ugly performance year 2018 for spread products. A first observation from this perspective is that positive total returns in fixed income may be hard to achieve next year, with low credit yields and government bond yields. Nevertheless, relative to expected government bond returns, positive excess returns for spread products may still be possible. This would be achievable with a continuation of the solid macro backdrop as well as a gradualist approach in central bank policy normalization. As things stand today, such an outcome would be our base case.

Which variables to watch in 2018?

Major corrections in spread markets historically rarely occur outside recession periods and as we do not foresee such occurrence next year, excess returns of spread products may still be positive. Recession probabilities nevertheless require close monitoring throughout next year, as any uptick in these metrics will be swiftly discounted in mark-to-market pricing of spread products. Together with investors’ perception over monetary policy, these are likely the key variables to watch. For central banks, inflation dynamics will remain in focus. Both in developed and emerging markets, inflation seems bottoming out currently, albeit from mostly low levels. Any upside inflation surprises in this respect require close monitoring, as this could imply a central bank policy repricing from still very accommodative levels. The Fed seems a likely candidate in this respect. Rising Fed rate expectations would likely affect spread products at large and EMD in particular. Nevertheless, if these upward inflation dynamics materialize against a strengthening global macro backdrop they should not fully derail spread markets. It would be important in this respect to monitor investor flows towards fixed income, as the unconventional central bank policies in the aftermath of the crisis orchestrated a major search for yield in fixed income and spread products in particular that could be at risk of reversal. A rotation from fixed income to equity would be a forceful headwind for spread products.

Another variable worth monitoring is bank credit standards. As things stand today, banks are still easing credit standards for firms in both the US and Eurozone. This is important, as bank credit standards are leading corporate defaults (tightening standards lead defaults) and hence spreads. As yet, it appears not an imminent risk.

Linked to credit standards is government bond yield curve steepness. The flattening of the US Treasury curve (2 to 10 year) to below-historical average steepness is a remarkable phenomenon in this respect. Outright inversion would be a clear warning sign as it tends to occur around recessions. Again, we are not there yet, but a flattening yield curve may hurt financial corporates which may lead to a tightening of credit standards and a subsequent rise in defaults. Similarly, and likely to occur in tandem, the relative (under)performance of financials in equity markets could be a leading indicator for spread products. So far this year, financials have performed roughly in line with the overall market.

As we saw throughout 2017, spread products may get pressured by risk-off patterns which at first sight are unrelated to the underlying fundamental currents. Geopolitical events are instructive for mark-to-market pricing from this angle and therefore require monitoring. North Korea is an obvious candidate but increased tensions in the Middle East have the same potential. In addition, political uncertainty like Brexit negotiations, independence aspirations in Catalonia, the upcoming Italian elections, coalition formation in Germany, or the likelihood of US policy agenda effectiveness in terms of tax reform, protectionism and environmental issues are all market moving factors. However, neither of these appears an imminent risk factor currently.

On the policy and macro front another usual market moving suspect is China. As yet, the Chinese economic slowdown seems orderly with an increasingly more credible market economy restructuring agenda.

In terms of other potential market disturbing events one could think of a de-rating of technology stocks or a renewed slide in oil prices. Regarding the latter, we expect the market focus in 2018 to shift to the exit strategy of production cut deal participants, the battle for market share and the return of US shale. Something to watch, but again, demand as yet remains supportive.

Finally, other leading metrics worth monitoring are volatility (VIX and MOVE indexes, which are currently low), issuance quality (weakening), upgrades versus downgrades (positive), distress ratio (low), or interest coverage (high). Approaching year-end, liquidity indicators (bid–ask spread) may be instrumental as well, to which MiFID regulation may add at the turn of year.