As the European Central Bank and the Bank of Japan prepare to wind down their asset purchase programmes, we stand “at the end of a cycle like no other”, claims Danish investment bank Saxo Bank in its 2018 Q2 outlook report.
In the aftermath of a near decade of QE the “downward trend” in interest rates over the last three decades will end, argued Steen Jaobsen, chief economist at Saxo Bank in the report. “This has enormous implications – the world has amassed $237trn (£175trn, €199trn) of debt with little growth to show for it.”
The rest of the year will see “the gradual degradation of corporate credits”, said Saxo Bank fixed income specialist Althea Spinozzi. As a result, an increase in bond market volatility appears likely over the coming months, as 10-year US Treasury yields hit 3% and the US Federal Reserve remains focused on monetary tightening.
“We believe that in Q2 we will see intensifying signs of distress in the corporate [debt] space which may provoke confined periods of volatility. However, a more severe sell-off [in bond markets] will not happen until the end of the year.”
Corporate bonds within the lower investment grade space (BBB/Baa) are widening surprisingly fast as the chart above shows.
The next chart (above) shows investment grade versus high-yield spreads, and illustrates that the former are widening faster than the latter. “Investors should be concerned about this trend, as it is a clear sign that valuations are too tight according to the rising risk,” Spinozzi said.
Moreover, these market shifts are taking place at a time when companies are issuing more bonds or refinancing existing debt to take advantage of favourable market conditions.
EM debt less attractive
In a volatile environment characterised by rising interest rates, emerging market debt and BBB- rated bonds are less attractive options, according to Saxo’s report.
On the other hand, blue-chip bonds guarantee good returns in a volatile environment.
“Although weaker credits are normally the first to suffer from rising interest rates, we believe that interesting opportunities can be still found within short-term high-yield bonds,” Spinozzi adds. “Defaults are still at historic low levels and looking at maturities up to three years, investors can find still risk-reward opportunities that would enable them to lock in yield for a specific period.”
Equities, meanwhile, are under pressure on many fronts, ranging from a potential trade war to disappointing macro numbers and technology regulation, according to Peter Garnry, head of equity strategy at Saxo Bank. “Caution is critical in such an environment and portfolio diversification and defensive choices therefore make sense.”
“We recommend investors to be overweight defensive sectors such as health care and consumer staples, as well as interest rate-sensitive sectors including utilities and telecoms as rate expectations could take a hit in Q2 while markets digest the changing landscape.”
According to Saxo Bank quantitative analyst Anders Nysteen, it’s important in the current market environment to have a portfolio not just with “soft” assets but to be prepared for sudden market changes with a more diversified portfolio including “hard” assets such as commodities and real estate.
“With the current slightly negative credit impulse and highly indebted financial system, minor events could trigger increased uncertainty in the market, leading to a further expansion of the corporate spreads,” he said.
Chinese industrial group Zhejiang Geely – which owns Swedish carmaker Volvo Cars – acquired a majority stake in Saxo Bank last year.
Saxo Bank, which brands itself as a fintech specialist, derives most of its income from its online trading platforms for private foreign exchange traders rather than traditional banking.