2020 Credit Outlook

Despite fears at the start of the year and continued trade tensions, 2019 delivered strong performance in financial markets but we see some clear headwinds in 2020 as we all adjust to the new norm of low interest rates for longer.

Executive summary

• While the global economy evidently experienced a slowdown during 2019, we are ending the year with a slight feeling of relief considering some of the doom and gloom scenarios that some were considering back in January. It is undeniable that the US/China trade tensions have grabbed everyone’s attention and affected broader business confidence but timely actions by global central banks have so far appropriately contained any potential negative reactions.
• In this context, financial markets have performed extremely well, with equities close to their historical highs and the material drop in risk-free rates driving very strong returns for the fixed income markets. However, we are seeing some signs that all might not be as rosy as it seems, which highlights the need for caution, especially as investors are on an undeniable search for yields.
• We expect 2020 to deliver a slight rebound in growth compared to 2019, noting that we believe that the potential outcomes are asymmetric, with the magnitude of any upside potential being materially smaller than what a downside case could deliver. However, we do not see a scenario which could deliver a steep decline as was experienced during the GFC.
• On balance, we view 2020 as a likely year of stabilisation, with interest rates globally experiencing some minor downward adjustments but not to the same extent as 2019. Further we believe that default rates could marginally rise given current accommodative lending conditions and the continued search for yield which provides easily accessible and cheap financing, even for companies of poor credit quality.
• For these reasons, we continue to believe that a conservative approach to fixed income investments should be favoured and it is critical to accept that historical yields are simply no longer achievable without substantially increasing risks. For those chasing yields, diversification is a ‘must’, as is portfolio granularity to ensure no single exposure can materially affect overall portfolio performance.

Brief synopsis of 2019

I may be alone in my thinking but, as we head towards the end of 2019, there is a slight feeling of relief about what this year could have been considering where we were back in January. Twelve months ago, we had experienced a year of significant economic and political uncertainty which culminated in the last quarter of 2018 being one of the worst in recent times, both from an equity and a fixed income perspective. When 2019 kicked off, there were growing concerns that the US-China trade war would become a lot worse despite strong initial expectations of a rapid conclusion. President Trump was mounting pressure on the US Federal Reserve, with threats to remove Chairman Powell, a change that would have undoubtedly unnerved markets given the accepted premise that Central Bank policies should remain independent from political considerations. In other words, we were bracing ourselves for a potentially very bumpy year.

In practice though, and despite some worrying events as described below, 2019 delivered a return back to some form of stability. In fact, one could argue that 2019 provided an idea of how the new normal might look. It is undeniable that interest rates are at historical lows and inflation remains stubbornly absent around the globe. In reality, we may need to adjust our expectations for a return back to long term averages. Conventional wisdom has always dictated that low unemployment rates drive higher wage growth, which would in turn lead to inflationary pressures that could be controlled through higher interest rates. The key factor though is that unemployment currently does not factor the increased under-employment (whereby people currently employed want to work more) which keeps a lid on wage growth. One has to wonder if the rule book needs to be revised.

US/China Trade War

Figure 1: US & China Import Index

Similar to 2018, the tensions between the US and China have continued to grab the headlines all year, with the constant question: “will they/won’t they finally reach an agreement?” Figure 1 provides an indication of how imports from one country to the other have evolved since the beginning of 2018. A downward trend is evident in both lines indicating that the trade tensions are affecting both countries. However, the US could clearly claim victory, as the data points to a reduction in their trade deficit with China. Further, it should be noted that the spike in US imports from China in late 2018 was primarily a reflection of the timing of certain tariffs being imposed, highlighting an influx of orders ahead of implementation. Looking through the data a bit more deeply, it appears that China is currently suffering more, especially considering Chinese industrial profits are currently 9.9% lower than a year ago, while remaining broadly flat in the US.

Hong Kong Unrest

What began as demonstrations against a proposed bill in front of the Hong Kong legislative council (that would have made it easier for people in Hong Kong to be extradited to mainland China) has turned into major civil unrest in the former British territory. Although the bill has long since been withdrawn, the events that continue to affect Hong Kong have moved to a much larger agenda focussed on ensuring that the ‘one country – two systems’ arrangement remains in place. While the unrest has clearly affected Hong Kong’s economy, its impacts haven’t spread across the region. However, this will remain a key topic, especially as the US Senate recently passed a Hong Kong bill aimed at protecting human rights in the territory. It is clear to see how this could become a key factor in the trade negotiations between the US and China.

Saying that, civil unrest has not been limited to Hong Kong this year, with similar uprisings (of varying importance) in Europe and South America. Political instability is clearly growing currently globally.

Figure 2: Hong Kong Annual GDP Growth

ESG Focus

Figure 3: Green bond issuance

2019 has somewhat marked a turn in the focus on Environmental, Social and Governance (ESG) matters. Long seen as ‘nice to have’ by many corporates around the world, these issues have moved to become a mainstream focus of interest for the broader investor community. A clear example in people’s mind tends to be the exponential growth in the issuance of green bonds with increased numbers of corporate and public sector entities tapping this market (see Figure 3). What became evident over the year was that the ESG focus is actually far broader than increased issuance of green bonds. Certain sectors, such as those tied to gambling or tobacco, are facing growing headwinds. This is also starting to affect the commodity sector, and in particular coal, where many investors and banks no longer wish to provide financing. To date, we believe the increased ESG focus is impacting price for these issuers rather than funding availability as there remains sufficient investor demand, although the overall demand pool is decreasing.

The Inverted Yield Curve Argument

Over the course of the year, as the yield on US 10-year Treasuries gradually declined toward the level of US 2-year Treasuries, the debate grew louder about the significance of the inversion of the yield curve, whereby short-dated Treasuries have higher yields than longer dated instruments. Historically, there has been a strong correlation between an inversion and an upcoming recession in the following one-to-two years.

The debate was particularly heightened in late August when the 10-year Treasuries dropped to 1.47%, with the 2-year at 1.52%. Saying that, many believe that this simple correlation is overstated, in particular as term premium (i.e. the increased return investors are demanding to hold longer dated securities) has materially dropped in light of low to very low long-term inflation. This means that, in the future, long-dated treasuries may never drive a premium of 200bp to 300bp (compared to shorter instruments) as might have been seen in the past, resulting in an inversion becoming potentially more frequent but less meaningful.

Figure 4: US Treasury – 10 Yr v 2 Yr

Other events that would have probably made the top of the list at different times included:

• Continued tensions in the Middle East: The situation in the Middle East has remained on high alert. In May, the US announced it was withdrawing from the Iran Nuclear Treaty signed in 2015 and reinstating sanctions against Iran. The tensions intensified in August when Iran shot down a US drone over the Strait of Hormuz and culminated in September with the attack of one of Saudi Arabia’s largest oil infrastructure assets. In other times, this could have rapidly escalated but tension, almost surprisingly, rescinded almost as quickly as it grew.
• Brexit: More than three years have passed since the historical Brexit referendum in the UK and the country remains divided. Over 2019, the Boris Johnson government suffered multiple losses in Parliament over Brexit, including when it was forced to adopt the Parliament’s timetable. However, with a recent Conservative win at the latest general election where Boris Johnson gained a majority on the back of an election campaign that was a de-facto second referendum, the path has become clearer to a Brexit that will now likely be delivered in early 2020.

How did all these events translate into the financial markets?

After suffering the effects of an ever-lasting roller coaster in 2018, financial markets were largely indifferent to the twists and turns that 2019 provided. However, describing 2019 as a return to normality would not accurately summarise the market conditions over the past 12 months. With the last global recession about 10 years ago, the general consensus remains that the global economy is towards the end of the current economic cycle but nothing seems to be willing to give way. Equities continue to remain at historical highs, with the S&P500 index reaching 3,000 points in July and both US and Australian stocks at all-time highs in late November. While traditionally, equities and bond yields have moved in opposite directions, currently bond yields are at or close to historical lows. In times of optimism, equity markets perform strongly, meaning they present better opportunities than bonds, driving down prices (and therefore increasing yields). Conversely, at times of uncertainty, investors will move to lower risk assets, such as bonds, which drives demand for Treasuries, pushing prices up (and yields down). While government bonds have moved higher from their lows in late August (at the time of rising Middle East tensions), movements during the year have broadly followed rate cuts by both the Reserve Bank of Australia and the US Federal Reserve, with both institutions ending the year with three rate cuts each.