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Credit spreads tighten further, but for how long?

One of the recurring themes we have been talking about over recent months has been the robustness of credit markets in general, particularly the riskier part of the spectrum such as High Yield and Emerging Market credits, and the remarkable performance registered so far during the first six months of 2017.

Credit markets posted yet again another remarkable performance during the quarter, as there seems to be no signs of the global search for yield abating for the time being. Price returns across both regions were the greatest contributors to total returns in both instances.

Economic data has been resilient, both in the Eurozone and in the US, and this was translated into yet another positive string of corporate results in the early days of Q117 earnings season whilst manufacturing and services data, as measured by PMIs have also surprised to the upside.

Unemployment in Europe for example data has been creeping lower and has recently fallen to its lowest in almost eight years. Inflationary data has also been slowly ticking upwards, with the European Central Bank revising its forecast for inflation upwards to for 2018 and 2019.

Investors were welcomed by positive trading screens in the aftermath of the first round of elections in France as risk-on mode moved from first gear to fifth gear in the initial minutes of the trading session, as risky assets rallied across the board. From High Yield bonds to peripheral bonds, to a strengthening euro to emerging markets, but European equities were the clear winners during yesterday’s trading session, particularly those highly exposed to France.

The European banking sector was one of the key outliers, with equities and deeply subordinated bank debt rallying sharply. On the flipside, the safe haven government bonds particularly in Germany bore most of the brunt of the risk on mode, which ensued.

Economic data has been resilient, both in the Eurozone and in the US, whilst manufacturing and services data, as measured by PMIs have also surprised to the upside. Unemployment in Europe has been creeping lower and has recently fallen to its lowest in almost eight years whilst US economic data has also remained robust.

To date, emerging market credit has been the clear winner, with the performance witnessed in EM bonds very difficult to ignore, and even more so, harder for an investor not to be participating in. Emerging markets have offered a pick-up in yield and spread terms on a like for like basis in comparison to similar rated and dated High yield issuers, and with a flat yield curve in developed economies, monies are expected to continue to flow into emerging market credit

On another note, whilst European Sovereign bonds had a remarkable run in April and May, this rally came to a halt as rates were extremely volatile during the month of June on the back of hawkish comments by central bankers, and Maltese Government bonds were not immune to this movement. The market interpreted comments by ECB’s Draghi and the Fed’s Yellen and Carney to signify that a tightening policy in both regions is warranted and possibly on the cards in the months ahead, which resulted in a sharp sell-off in sovereign bonds.

The attempt of a bond price recovery was timid and short-lived as higher-than-expected inflation figures and an overall hawkish tone pushed bonds lower once again. We are of the opinion that the moves could be a snippet of what volatility could be like once the ECB announces a further QE reduction.

It seems apparent that, now more than ever, markets are paying attention to central banks’ reminders and warming to the fact that rates will not remain low forever. In the coming weeks/months, we

continue to expect the ECB to move further towards exiting its quantitative easing programme (QE) through an announcement of another reduction in the pace of its asset purchases. 

This article was issued by , Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.   

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