Global credit cycle facing monetary policy curveballs
Global financial markets have recently been experiencing bouts of volatility as a result of a rising rate backdrop. The latter was triggered by the signaling of a tightening bias by the Federal Reserve chairman on May 22nd and the outlining of a potential 2014 asset purchase exit strategy on June 19th. Consequently, rate sensitive and high duration asset classes have experienced capital losses. Moreover, the unwinding of global carry trades has impacted Emerging Market (EM) asset classes and higher U.S. yields have accentuated the declines in emerging market currencies. Financial markets have also been concerned with a tightening monetary stance in China, whereby the authorities are attempting to clamp down on excess credit creation by its shadow banking system. In terms of our investment strategy, we continue to be positioned in low duration non-agency MBS. Recent price action in this asset class has held up better than higher duration fixed income instruments. In equities, we remain opportunistic in improving the risk-reward profile of our portfolios; with a preference for large-cap cash rich companies that have long product cycles.
As we can see below, the increased visibility into the Federal Reserve’s exit strategy has caused a rapid move in global bond yields. Apart from sovereign debt instruments, rate sensitive and higher duration asset classes have been particularly impacted e.g. corporate debt, municipal bonds and agency MBS. We have been avoiding these interest rate sensitive asset classes. Moreover, we have been paring back our MLP positioning in recent weeks. In retrospect, Apple’s record breaking $17 billion bond offering on April 30th appears to have been a seminal moment in the interest rate cycle.
Emerging Market asset classes have been impacted to a large degree by the unwinding of global carry positions. As we can see below, emerging market instruments have quickly priced an increased risk for capital outflows. Emerging markets have been beneficiaries of the global reach for yield and as we discussed in part articles, structural hurdles and lower global growth have led to balance of payments pressures. Outflows from dollar denominated or local currency debt instruments are likely to put pressure on countries that face current account deficits and heavier reliance on short-term financing. Therefore, we are assessing EM credit conditions and how the global business and credit cycle may be affected.
Chinese equities continued to weaken due to money market and interbank financing concerns. Chinese authorities have been attempting to curb excess credit creation that has been driven in the past few years by the expansion of the shadow banking system. More specifically, Chinese depositors have been investing in short-term higher yielding instruments (Wealth Management Products). In our view, even if systemic risk is averted, at a minimum we expect slower credit creation and slower GDP growth. Thus, we are assessing the degree to which a Chinese slowdown may impact global growth and how European economies may be affected as they have higher leverage to Asian growth than the U.S. economy.
Given all of the above, the key question for investors is how global and U.S. growth will shape up in the coming quarters and into 2014. Historically, the beginning of monetary tightening cycles did not signify an end to the business cycle. On average, business cycles turn after central banks stop tightening. The challenge this time around is whether global growth can cope with tighter fiscal policies and extended monetary programs. On the other hand, with more balanced fiscal and monetary policies, the corporate sector may gain the necessary confidence to deploy its surplus savings and drive the next leg of the current business cycle. Thus, it will be important to see whether CEOs will shift their emphasis from financial engineering towards more capital expenditures and hiring. On the U.S. growth front, we highlight the ongoing strength in the housing market which lends particular support to household wealth. We also highlight the ongoing decline in inflation expectations. Persistent dis-inflationary trends may prod the Federal Reserve to stretch the timeline of its exit strategy.
In conclusion, we continue to assess the risk-reward profile of various asset classes in fixed income and equity markets. We are opportunistic in restructuring our portfolios in anticipation of any turning points in the global credit and business cycles. We maintain our preference for low duration non-agency MBS and late-cycle/secular growth equity themes.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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