By Mondher Bettaieb
Looking back nearly a decade to the year 2006, there were two major events that have not been repeated since: The Fed raised rates and Italy won the football World Cup. The former is now looking very likely to be repeated, but for the latter, the Italian people will just have to continue to live in hope.
Point being that a) it was a very, very long time ago and b) the world has changed quite a bit since then. It is therefore understandable that the possibility of a Fed rate hike is something that the market finds itself fixating upon. (In fact, at time of writing, the probability of a Fed rate hike in December is estimated at 80%). However, the will they/won’t they debate about a December hike is immaterial, what is really at issue is the possible beginning of a rate hike cycle: not just one hike, but a series of hikes.
However, when the hikes do start coming it is unlikely that they will be as aggressive as many people fear. They will be gradual and come over a long period of time; more of a crawl than a jog. There are several reasons for the Fed not to hurry, but two reasons in particular stand out: low inflation and low growth. The numbers to support this are clear: the Fed’s own forecast is for its Fed funds rate to be at 3.5% by 2018. With core inflation in the US at below 2% and with economic growth flat, there is not much out there to drive inflation further up. Therefore, the Fed’s estimate seems rather aggressive.
Now, let’s take a step back and look at the broader economic picture. Both productivity and investment levels in the US are low, when there is no investment and when productivity is weak, people do not receive salary increases and as a result, consumers are afraid to spend. All these attributes are disinflationary in their outcome and this is one of the key reasons why central banks are unlikely to increase interest rates in a hawkish manner.
The key point here is that all the ingredients are in place for a longer than usual credit cycle. In the past, credit cycles would last about five years, this time round – if this regime of low growth and low inflation can be maintained – the cycle could last anything from seven to ten years. For corporate bond investors (investment grade and high yield) this makes for a benign environment, because with corporate bonds there is a spread which represents the risk of the credit that an investor is taking on.
Today, global investment grade has a spread of about 180 basis points (bps), which offer value, even if the US economy slows a little bit on a temporary basis – this more than prices in that risk. These types of spreads really represent what are usually seen during a recession and there’s definitely no recession at the moment. Yes, there’s low growth and yes, there’s low inflation, but no, there’s no recession. As for high-yield bonds (often referred to as “junk”) the spreads are now back at around 600bps, which represents an implied default rate of about 35%, when actually, next year’s forecast for default should be just about a tenth of that (3.8%).
So overall, on a global basis, corporate bonds remain very attractive indeed. As the Fed begins a hiking cycle that is likely to be much slower than many market participants anticipate, investors should look to ride the spread carry run by collecting the carry from corporate bonds in what is likely to be an unusually long credit and expansion cycle.
Mondher Bettaieb is head of corporate bonds at Vontobel Asset Management
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