Liontrust’s Stuart Steven explains why he is cautiously positive on two major macro risks.
Credit spreads have widened out over the summer on the back of renewed weakness in the global economy, primarily resulting from heightened concerns over US/China trade negotiations and fears over the possibility of a no-deal Brexit. Notwithstanding this deterioration in sentiment, we continue to believe the economic backdrop remains supportive for corporate bonds.
Overall, despite the warning lights, the risk of a global/US recession is low and we see three main supportive factors.
First, the service sector, the largest component of developed economies, remains strong, bolstered by low unemployment, positive real wages, and robust housing markets.
Second, central banks continue to be supportive, with the US Federal Reserve recently cutting rates for the first time since 2008, the European Central Bank signalling its intent to ease (via rate cuts and/or further balance sheet stimulus), and the Bank of England reversing its rhetoric on the need to hike in the face of Brexit.
Finally, corporate profitability remains relatively strong and credit metrics, especially within investment grade, are being managed conservatively.
Looking forward, although credit spreads will continue to be influenced by headlines over trade wars and Brexit, we ultimately believe that corporate bonds will outperform government bonds.
Ultimately, credit valuations are (selectively) attractive and central bank initiatives will continue to support economies and credit markets. Meanwhile, historically low government yields in the UK and Europe encourage investors to buy investment grade credit, particularly if spreads are relatively attractive.
We also continue to be cautiously positive on the two major macro risks, believing that a full US/China trade war will be avoided, as will a no-deal Brexit.
On the former, it is not in President Donald Trump’s interest to continue to slow the US economy and stockmarket ahead of his re-election campaign. China has plenty of fiscal/monetary firepower, along with other measures such as restrictions on exporting rare-earth minerals, which could hurt the US economy.
As for Brexit, we feel that a no-deal would be political suicide for the Conservative Party for a swathe of reasons.
First, it is likely to put the UK into recession, causing high-profile blockages in the supply chain, and politically speaking, it would make a mockery of their traditional position as the party of business/economy.
To invoke a no-deal, they would need to push the boundaries of governmental power and undermine parliamentary democracy, with more than 60 Conservative MPs opposing leaving without a deal. The current strategy is one of attempting to improve their negotiating power.
However, the risk of an accidental no-deal Brexit is real, although we believe that, in this scenario, the Bank of England would step in to do what is necessary to support the economy and financial markets – as it did after the initial referendum result in 2016.
In terms of our portfolios, we continue to believe that valuations on UK credit are attractive relative to their core European and US company equivalents, and the funds have limited direct exposure to sectors that would be most exposed to the short-term impacts from a no-deal, namely those exposed to imports and exports, such as industrials, oil and gas, consumer goods and technology.
We also have a focus on high-quality names in the banking (robust capital/retail banking focus) and insurance (very high levels of solvency) sectors.
In summary, while it could be a bumpy ride for credit leading up to 31 October, we continue to believe that credit will outperform over the medium to long term as the issues described above are resolved or overcome.
Stuart Steven co-manages the Liontrust Monthly Income Bond fund.