Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Schroders fixed income fund manager Michael Scott gives his outlook for European corporate bonds.
For much of 2017 we witnessed an extended period of higher bond prices supported by central bank policy and improved global growth momentum. By the end of the year, there was very little room in valuations to compensate investors for unexpected risk.
As we go into 2018, we observe an ongoing upswing in the global economy, with data indicating that Europe is at the peak of the economic cycle. From its current position of strong growth, the potential for upside surprises in Europe is likely to be limited.
The US economy has remained resilient, despite questions over the ability of the Trump administration to deliver on promised economic reforms. If the administration can start pushing these through, and recent evidence seems to support this, the US economic cycle could extend beyond 2018. The impact on inflation would need to be monitored carefully, however.
Emerging markets have performed well, particularly in Latin America, supported by local political and economic reforms, the global upswing in growth and careful, progressive normalisation of US Federal Reserve monetary policy.
Federal Reserve Leads the Way
We are seeing central banks changing direction very carefully, led by the Federal Reserve, which is raising interest rates and reducing its balance sheet. Globally, the process of withdrawing loose monetary policy is in train, but at a gradual pace.
This is likely to continue in 2018, with growth and inflation being a key guide, especially if the US government cuts taxes. We should expect the Fed to continue on its current course.
The European Central Bank is likely to move glacially towards the end of quantitative easing (QE) while remaining very sensitive to any signs of weaker economic and inflation data.
Although the Bank of England has sent a message of intent by raising interest rates, policy will likely be guided by the headwinds generated by Brexit and the direction of sterling and inflation.
On the one hand, peaking growth and the impact of globalisation and technology continue to argue against concerted central bank action. On the other, ongoing employment growth and the potential for significant tax cuts in the US could drive inflation higher.
With the consensus expecting inflation to remain benign, we do see potential upside risks. In Europe, the consensus view is that the ECB will reduce the level of monetary easing at a very conservative pace.
As such the market will be sensitive to any perceived change in tone from the ECB. On balance, interest rates are unlikely to rise sharply in 2018, and if all else remains equal, gradually higher yields should be welcomed by credit investors.
UK Companies Still Resilient
Improvements in European earnings and some debt reduction have led to a decline in investment grade and debt levels on company balance sheets over the last year.
With European growth peaking, a slowing of growth momentum could pose a downside risk for corporate earnings and increase debt levels. Although we are not forecasting a material slowdown in momentum at this point, earnings downgrades would likely be a source of volatility if valuations remain at these extended levels.
Brexit is clearly a challenge for the UK, but we have not seen a material uptick in profit warnings, despite higher inflation data and more regulation, suggesting that companies have remained very resilient. Brexit headwinds will likely discourage companies to invest, and this could further impair already poor productivity. It seems fair to assume that Brexit will continue to apply pressure on earnings in 2018.
Brexit Uncovers Opportunities
With valuations at broadly high levels, there is little compensation for unexpected risk, and so we should expect to see more periods of volatility. If economic and credit fundamentals remain broadly supportive, then volatility is likely to reveal opportunities to buy good quality bonds relatively cheaply.
In-depth credit research is the key to identify these value opportunities and determine the resilience of companies’ business models to oncoming challenges. For example, the uncertainties posed by Brexit are likely to exert a drag on UK businesses. This has undermined investor sentiment towards the UK corporate bond market. We think that this is uncovering attractive opportunities to invest in sterling corporate bonds, in both investment grade and high yield from selected companies that we believe have robust fundamentals.
We are already seeing a rise in leverage in the loans market, which combined with looser creditor protection, suggests a late stage in the credit cycle. Loose monetary policy creates loose financial conditions, and as we are at an advanced stage in the economic growth cycle companies will be tempted to extend growth by engaging in mergers and acquisition activity. M&A activity has been subdued in Europe in 2017, and even in the US, where M&A has been relatively higher, activity has fallen recently.
Nevertheless, we will continue to monitor for signs of any increase. We see little evidence to suggest new issue supply will increase materially in 2018, but we do think that investors will demonstrate more discretion over the quality of new issues.
Europe is Near the Peak in the Economic Cycle
The market is providing little by way of a cushion in valuations to compensate for unexpected risks. Macroeconomics aside, there will be a general election in Italy in 2018, while political uncertainty will likely persist in Germany and Spain. The development of nuclear weapons by North Korea will likely continue causing concern to the US and regional allies. Risks such as these may prompt short-term volatility and will need to be monitored carefully.
We remain constructive towards European credit. However, we are probably near the peak in the economic cycle, defaults are very low and valuations near the highs, with little compensation for unpredicted risks. We should therefore expect volatility to return to more ‘normal’ levels going forward. This would create more divergence in companies' short-term returns, but also generate more opportunities to add value through active management and security selection.
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