Is the Turnaround of China’s Economy Real?

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¿Cómo sortear la volatilidad en China?
CC-BY-SA-2.0, FlickrPhoto: Carlos ZGZ. Surviving Chinese Volatility

Despite strong concerns at the start of the year, at Pioneer Investments, they believe that overall economic conditions are stabilizing, backed by a more aggressive policy stance, better fiscal supports, recovery of the real estate sector and credit growth, while consumers and the private sector have remained relatively resilient. Tail risks of a hard-landing in the near term are easing meaningfully.

Policy stance: 6.5% GDP Growth is the Floor

Following China’s annual National People’s Congress meeting (NPC) in March, policymakers sent relatively strong messages regarding their stance this year, which is likely biased towards the easing side.

The GDP growth target for the year was announced as the 6.5-7.0% range. According to Monica Defend, Head of Global Asset Allocation Research with Pioneer, the floor of 6.5% is probably a harder target than others. In other words, if growth risked breaching the 6.5% floor, policy support would turn stronger than planned, while support could ease if growth reached 7.0%.

Better Fiscal Support

“China’s overall fiscal and quasi-fiscal position is complicated, including the budget deficit, out-of-budget funds to local governments, net revenues from land sales, and changes of fiscal deposits in PBOC accounts,” says Defend.

The latest information allows us to have a more complete picture of the underlying fiscal & quasi-fiscal position, and suggests that fiscal policy is becoming more supportive and perhaps more effective.

The overall fiscal stance, including all budgetary and quasi-fiscal measures, became less supportive or even tightened beginning in late 2014 and through most of 2015, largely due to strengthening of regulations on local government out-of-budget financing and weak land sales.  Defend believes that the increase of central government spending was not sufficient to offset such weakness. But this seems to have changed since late 2015. And so she estimates that the overall fiscal and quasi-fiscal deficit will rise by around 1.5% of GDP in 2016 vs 2015. This is mainly due to:

  • The fiscal deficit has increased since late 2015 and the plan is for it to continue to rise.
  • Land sales are likely to at least stop acting as a drag in 2016, with further positive signs in real estate markets.
  • The creation of Special Construction Funds (SCFs) in late 2015, which policy banks use to inject capital into specific projects, mainly infrastructure-related. This new quasi-fiscal channel appears, relative to traditional out-of-budget local government borrowing, easier to regulate and manage, and thus more flexible and efficient.
Ampliar

Positive Signs in Real Estate

Easing of policy over the past year or so appears to have stabilized the real estate sector, with a visible rebound early this year.  Relatively strong sales have been pushing acceleration of existing projects and new starts have finally picked up.

Ampliar

Although property activity is still fairly weak for the country as a whole and price increases have been subdued, momentum in some large cities has been relatively strong. This has triggered a recent tightening of property purchase policy in a few large cities. But this is largely designed to prevent potential price bubbles in individual regions, rather than reflecting a reversal of a generally supportive policy stance.

“The latest data suggest that sales in Tier 1 cities have cooled somewhat, while overall sales have been relatively stable. While we expect only stabilization or a moderate recovery for the whole year, this scenario should be relatively sustainable.”

Conclusions

“Despite strong concerns about China’s economy at the start of the year, there is increasing evidence suggesting that the underlying situation has been stabilizing, with tail risks easing. This is buying more time for China to push structural reforms. We are conscious that the process is still long and not straightforward. A failure in reform implementation would add to medium-term risks. So far, we believe that the reforms are progressing nicely and that the transition of China toward a more balanced economic model is underway. For this reason, we are moderately positive on China, that is one of our favorite countries among emerging market universe,” she concludes.

To read Defend’s complete macroeconomic update, follow this link.

Columbia Threadneedle Investments to Acquire Emerging Global Advisors

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Columbia Threadneedle Investments adquiere una firma boutique centrada en smart beta
CC-BY-SA-2.0, FlickrPhoto: Glyn Lowe. Columbia Threadneedle Investments to Acquire Emerging Global Advisors

Columbia Threadneedle Investments announced on Wednesday an agreement for Columbia Management Investment Advisers, LLC to acquire Emerging Global Advisors, LLC (EGA), a New York-based registered investment adviser and a leading provider of smart beta portfolios focused on emerging markets. The acquisition will significantly expand the smart beta capabilities of Columbia Threadneedle Investments. Terms of the EGA acquisition were not disclosed. The transaction is expected to close later this year. 

With $892 million in assets, EGA has an established presence in the smart beta marketplace. It is the investment adviser to the EGShares suite of nine emerging markets equity exchange-traded funds (ETFs) that track custom-designed indices:

  • Beyond BRICs (BBRC)
  • EM Core ex-China (XCEM)
  • EM Quality Dividend (HILO)
  • EM Strategic Opportunities (EMSO)
  • Emerging Markets Consumer (ECON)
  • Emerging Markets Core (EMCR)
  • India Consumer (INCO)
  • India Infrastructure (INXX)
  • India Small Cap (SCIN)

 “The experience and knowledge of the EGA team and strong emerging markets ETF products will complement our existing actively managed product lineup,” said Ted Truscott, chief executive officer of Columbia Threadneedle Investments. “The EGA acquisition will allow us to reach even more investors and accelerates our efforts as we build our smart beta capabilities.”

Since launching its first ETF in 2009, EGA has had a dedicated focus on providing rules-based, smart beta strategies designed to provide investors with diversification and growth opportunities in emerging markets.

“The team is excited about joining Columbia Threadneedle Investments and building on our complementary strengths to deliver smart beta strategies across asset classes to investors,” said Marten Hoekstra, Chief Executive Officer of EGA. “Now our clients gain access to Columbia Threadneedle’s rich investment expertise, while continuing to benefit from EGA’s experience converting investment insights into rules-based, smart beta strategies.”

“Columbia Threadneedle Investment’s expansive footprint across global markets provides an opportunity to accelerate the growth of our smart beta platform,” said Robert Holderith, President and Founder of EGA.

As part of their efforts to enter the smart beta marketplace, in the first quarter of 2016 Columbia Threadneedle Investments filed with the SEC a preliminary registration statement relating to multiple equity smart beta ETFs, including Columbia Sustainable Global Equity Income ETF, Columbia Sustainable International Equity Income ETF and Columbia Sustainable U.S. Equity Income ETF (referred to as the Columbia Beta AdvantageSM ETFs).

 

Credit Markets: Confidence Returns, but is it Sustainable?

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La confianza ha vuelto a los mercados de crédito, pero ¿es sostenible?
CC-BY-SA-2.0, Flickr. Credit Markets: Confidence Returns, but is it Sustainable?

Stephen Thariyan, Global Head of Credit at Henderson, reviews the credit markets in Q1 highlighting the ‘two-thirds—one-third’ nature of the markets. Financials came under particular pressure over the quarter exemplified by Deutsche Bank’s ordeal. While investors are happy to be back in the markets for now, as central banks have acted effectively to bring confidence back, challenges lie ahead in 2016. Thus, Stephen believes investors should be prepared for volatility to resurface.

Can you give a brief summary of corporate bond markets in Q1 2016?

It was a tough start to the year. It seems that in the first two months, particularly in February, the markets were discounting all the possible bumps in the road for 2016: concerns about central bank policy, illiquidity, Brexit, the oil price, China and growth in general. This led to quite a major sell-off across all capital markets, both debt and equity.

The end of February and March then saw a strong recovery, essentially based on the oil price, rallying from a low of US$26 upwards. That resulted in good returns, especially in high yield and emerging markets; total returns being positive across most currencies, across most credit markets, and excess returns again being broadly flat across most credit markets. So, a quarter of two thirds/one third: a very poor start and a strong recovery that continued into Q2.

Can you explain why the financial sector underperformed, particularly Deutsche Bank and subordinated banks/insurers more broadly?

The financial sector came under particular pressure in the first quarter. This was based on a combination of issues. Deutsche Bank in a way personified this with a situation that led to a significant sell-off in its bond prices, CDS and equity price. In a negative interest rate world, the core way the banks make money is challenged (ie, use short-term borrowing to lend for longer periods). This means significantly reduced returns from investment banking, especially in trading, fixed income, commodity and currency.

Banks, such as Deutsche, reported their first major loss in around eight years and there is a huge degree of outstanding litigation surrounding these banks, totalling billions. The last point was, especially with respect to Deutsche, concerns about the AT1 securities, contingent capital notes, which are complex subordinated financial securities, in existence to increase the capital buffer. There was a rumour that Deutsche would not pay its coupon, and even though these securities are designed to protect the public, the potential triggering spooked investors. Deutsche did recover the situation, but for the first time it felt a bit like 2008.

So financials generally took an awkward situation largely on the chin, given that central banks, especially in Europe, are trying to make banks lend money. Banks, however, are deleveraging, carrying lots of liquidity and struggling to find borrowers to borrow that money.

What is the outlook for credit markets and what themes are likely to drive the markets?

We are at an interesting point. We have suffered from a difficult first few months in 2016. The central banks have come in and almost acted in unison, with the European Central Bank subtly talking about a movement in monetary policy, but more importantly, the purchase of corporate bonds in the next few months. They haven’t given any details but the sheer fact that they are prepared to do it has given the markets confidence that there is a bidder for bonds.

It is debatable how effective that would be but the markets have rallied as a result. That combined with the Fed being a little more dovish a week later gave the capital markets, debt and equity, a huge fillip. Equity markets strengthened, bond markets strengthened, new issuance has started and the oil price steadied. A combination of all those events and generally benign data means that the investor seems happy to be back in the market again.

There is a degree of suspicion about how long this will last, but I think as we have said ever since the back end of last year, given all the different events that could occur in 2016, we are in for a volatile time. Certainly central banks have acted effectively so far in giving investors the confidence that they should be back in the markets buying both debt and equity.

 

Misperceptions of Thailand

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Ideas erróneas sobre Tailandia
CC-BY-SA-2.0, FlickrPhoto: Heribert pohl. Misperceptions of Thailand

On a recent research trip to Thailand, I had the chance to evaluate some commonly held misperceptions about the long-term outlook for the country’s economy.

One common misperception about Thailand, for example, is that its rapidly greying population makes its markets and companies relatively unattractive for investments compared to neighboring countries like the Philippines, Vietnam, Myanmar and Indonesia. We believe that this generalization discounts the dynamism of several Thai companies. The opportunity set for many companies extends beyond the country’s population of about 68 million. Thai companies have made progress, branching out to nearby countries to participate in their growth and to take advantage of more youthful populations. Similarities in culture and business practices have made it easier for companies to expand profitably in the surrounding region.

Another misperception is that Thailand, with its GDP per capita at approximately US$6,000, is stuck in a middle-income trap. The fear is that Thailand might not be able to graduate from an economy based on manufacturing and agriculture to one more specialized in services. The Thai economy does indeed need to restructure its workforce since roughly 42% of the population works in the agriculture sector, contributing less than 11% to GDP.

However, we believe that policy frameworks to enable the country to graduate to a knowledge-based economy are in place. For example, the government’s continued investment in education, which accounted for over 21% of the national budget in 2012, has resulted in a tertiary education enrollment rate amongst the highest in ASEAN.

A common mistake amongst foreign investors in recent years is to divide Thailand regionally along “Bangkok” and “Upcountry.” The inference is that the “Upcountry” is significantly under-developed and heavily dependent on agriculture. But based on our research, we believe that this division is, perhaps, too simplistic. For instance, our analysis of shopping mall operators has uncovered “rural” malls that are, in fact, in large towns thriving due to tourism and cross-border trade.

Economic Restructuring

We have also discovered that locals, especially bureaucrats, still believe Thailand to be quite resilient to various internal and external shocks. They call it “Teflon Thailand,” to suggest nothing can stick to it. But they may be overestimating that level of resiliency. Thailand still has not recovered from the 2014 national coup d’état. The replacement of the democratically elected government and appointment of a junta-led government has led to a period of both uncertainty and policy inaction. A consequence of this has been the loss of foreign direct investment market share to countries such as Vietnam, the Philippines and Indonesia.

We believe a restructuring of the economy is necessitated by Thailand’s aging population, slower global growth and competition from neighbouring countries. The government seems to understand the urgency of the situation and has unveiled a series of policies to improve the country’s basic infrastructure. Over the short to medium term, this should help. Over the longer term, we would like to see an environment that accommodates a more sustainable governance system that inspires confidence from local and foreign investors to commit long-term capital to the country.

Tarik Jaleel is research analyst at Matthews Asia.

Abenomics is Alive and Well

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Abenomics está vivo y en buena forma
CC-BY-SA-2.0, FlickrPhoto: Glenn Waters. Abenomics is Alive and Well

Despite the disappointment that the Bank of Japan (BOJ) did not act this week, one should not listen to those proclaiming the death of Abenomics. Indeed, it is alive and well.

Many people somehow suggest that Abenomics has so far been a failure, but this is only partially true if you were expecting miracles. The truth is:

  1. Even after its recent rise, the current level of the Yen compares favorably with the 78:USD level before Abenomics;
  2. TPP (the Trans Pacific Partnership) was successfully negotiated, which requires substantial economic reforms, especially in the heretofore heavily protected agricultural sector.
  3. The 2% CPI target was ambitious, but CPI ex food and energy is now near 1% compared to flat or negative prior to Abenomics
  4. Japan now believes in shareholder value, share buybacks and improved pretax profit margins, which have soared to record high, especially in the non-Yen sensitive service sectors
  5. Corporate taxes were lowered by a massive amount, so recurring net profit margins are improving even faster than pre-tax margins
  6. When looking at the overall economic picture, not the macro-economic statistics, which likely do not accurately reflect the new economy and often get revised, one sees full employment, stable or rising property values (after decades of wealth-sapping declines), and solid international competitiveness in advanced industries
  7. Political stability reigns whereas previously the prime minister was an annually revolving door; and lastly (although there are many more examples)
  8. Women are increasing their share of the labor force and over 200,000 kindergarten slots have been created in the last two years.

As for the BOJ, the likely reason why it decided to wait this week was to make certain that its next step was perfectly organized logistically, compared to its negative-rate decision in January. Certainly, the logistics for an ECB-style TLTRO (Targeted Longer Term Refinancing Operations)-like program is much more complicated than simply increasing QE purchases, and requires much more planning and transparency. But delay does not mean surrender, and if anyone thinks that Governor Kuroda is not fully dedicated to achieving positive inflation expectations, they are gravely mistaken and will likely be unhappily surprised when the BOJ takes its next large action, likely in June.

TLTROs, which provide negative-rate funding to banks if they can prove that it is going towards increased lending, are necessary, as in January, negative rates on excessive reserves led analysts to cut banks’ earnings estimates, which led to a broader equity sell off. Since price (including asset prices like real estate and equities, in order create the “wealth effect”) inflation is a key part of Abenomics, banks must not be penalized too much, or else lending and equity prices will not rise steadily.

Besides TLTROs, the next BOJ move will also likely increase the amount of bank reserves that are not subject to negative interest rates. We also expect an increase in ETF purchases to a level that will start to have monetary policy implications instead of just being symbolic of the BOJ’s desire to increase risk appetite by the Japanese people.

As for the fiscal “arrow,” “Helicopter money” is a vague and controversial term. If it means a hazard and extraordinary surge in fiscal spending financed by monetary injection, then such is not likely. However, Japan is soon going to increase fiscal spending substantially, especially due to the earthquake, and the BOJ will indirectly finance much of this.

Thus, the monetary and fiscal “arrows” will accelerate soon, while the economy is likely to continue growing at a moderate rate. It would be helpful if the US would pass TPP, but even if it does not, Japan will likely implement most of the reforms anyway, as such are obviously necessary, especially in the demographically challenged agricultural sectors. Other reforms, including in the labor markets, will also help prove that Abenomics is alive and well. It is critically important, however, that Japanese corporations are pro-active in this effort. They need to invest more locally, rather than abroad, and to be more creative, along with entrepreneurs, in creating new ventures, especially in green technologies. Abenomics is not just about the Prime Minister and his team, it is about Japan’s future as a whole.

John Vail is Chief Global Strategist at Nikko AM.

Jemstep, SigFig and Vanare Added to Pershing’s Platform

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Pershing firma con los roboadvisors Jemstep, SigFig y Vanare
CC-BY-SA-2.0, FlickrFoto: e_mole . Jemstep, SigFig and Vanare Added to Pershing's Platform

Invesco recently announced that it will collaborate with Pershing to offer Jemstep Advisor Pro, the firm’s digital advisor-focused digital solution, to Pershing’s clients. Jemstep Advisor Pro will enable RIAs and broker-dealers on the Pershing platform to seamlessly onboard prospects and effectively service investors. It is expected to be available on Pershing’s NetX360 platform in the third quarter of 2016.

“Pershing serves a wide range of investment firms including RIAs and broker-dealers, and the Jemstep Advisor Pro platform offers the capabilities to satisfy the needs across our spectrum of clients,” said Jim Crowley, chief relationship officer at Pershing. “Jemstep Advisor Pro is distinct in that it combines Invesco’s leading world-class investment capabilities with best-in-class digital technology to enhance the financial experience for advisors and end investors.”

Jemstep Advisor Pro is open architecture which allows investors to access a variety of professionally selected investment options across mutual funds and ETFs. Unlike peer tools that focus on market-cap-weighted indexing, Jemstep Advisor Pro also gives home offices new and differentiated insights to help track advisor progress, view client data in aggregate, enhance portfolio management offerings and services, manage risk, and an opportunity to broaden their client reach to address intergenerational needs.

Pershing has also added  SigFig and Vanare.

Time To Take A Step Back?

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¿Es hora de dar un paso atrás en los mercados?
CC-BY-SA-2.0, FlickrPhoto: Neal Fowler. Time To Take A Step Back?

As a disappointing first quarter earnings season rolls on, I am beginning to feel more cautious about the markets in the months ahead. We’re in the midst of a third consecutive quarter of poor profits and cash flows, and what’s most troubling is the weakness that’s spreading beyond energy and exporters to a broader swath of companies in the index. To me, this is a signal to reduce risk in many portfolios.

Why the increasing level of concern? The three previous earnings recessions of the last 50 years that were caused by a combination of tumbling oil prices and a strong dollar tended to last two quarters. But this pronounced downturn in earnings has now stretched into a third quarter. By now, I would have expected sales and profits to have rebounded, with consumers responding to the “energy dividend” that has accompanied the tumble in oil prices. And the pass-through from lower input costs should have driven an increase in overall economic activity, fueled by higher real consumer incomes. That has not yet happened. I find it both discouraging and an ominous sign for risk assets.

Reevaluate your asset mix

With new money, investors may want to contemplate standing aside for now. An appropriate response for existing diversified portfolios could be to reevaluate their quality mix, and to consider favoring a tilt toward shares in companies with sustainable dividend yields and toward high-quality bonds, perhaps US corporate credits.

Although I don’t believe the present backdrop signals the beginning of a US recession, it does mean that we are now experiencing a protracted earnings recession. To resume favoring risk, I’d need to see the following:

  • A recovery in capital expenditures
  • An improved revenue line for US-based multinationals
  • A sustained improvement in emerging markets
  • Improved pricing power on the back of an increase in global inflation

Additional concerns

Aside from the concerns expressed above, there are a number of other issues that the market needs to confront. In particular, because of the growing weakness in earnings, the current price-earnings ratio for the S&P 500 is too high, at 16.3x.

Seasonal trends are not particularly favorable in the months ahead. The May–October period is historically characterized by sideways market movements, delivering indifferent returns to investors when viewed over many decades. As the popular saying goes, “Sell in May and go away.” This year, in particular, investors can afford to wait for more clarity from the data flow.

Generally, market participants tend to be cautious in the months leading up to major elections. And with this year’s US election likely to be contentious, that caution may be justified. Further risks that may warrant caution are the Brexit referendum on 23 June and a Spanish general election days after, as well as concerns about Greece’s ability to meet its financial obligations over the coming months.

The macroeconomic environment has proven less dynamic than expected in recent months. US government income tax receipts have slowed despite still-robust employment data. New single family home sales, though solid, have not met my expectations. Auto sales are losing momentum after a very strong 2015. And most importantly, the profit share of gross domestic product, one of the most important forward indicators I follow, has started to slide.

While the current US business cycle remains strong by many measures, like job and wage growth and corporate profit margins, the equity markets are laboring to produce the earnings and margins that we’ve come to expect in recent years.

Our job will be to follow the shifts in the markets and the economy, and it’s our hope that our current concerns will be temporary.

But for now, it might make sense to take a step back.

James Swanson is Chief Investment Strategist at MFS Investment Management.

Roderick Munsters Appointed Global CEO Asset Management of the Edmond de Rothschild Group

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El grupo Edmond de Rothschild nombra a Roderick Munsters nuevo CEO de su firma de asset management
CC-BY-SA-2.0, FlickrPhoto: InvertmentEurope. Roderick Munsters Appointed Global CEO Asset Management of the Edmond de Rothschild Group

The Edmond de Rothschild Group has decided to entrust the management of all of its Asset Management business to Roderick Munsters from May 10, 2016. He replaces Laurent Tignard who leaves the Group to pursue new professional opportunities.

Edmond de Rothschild confirms its willingness to accelerate the development in France and abroad of one of the Group’s flagship business, representing over CHF 85 billion (€78 billion) in assets under management (at 31.12.2015).

Roderick Munsters (1963) has both a Dutch and a Canadian nationality. He was Chief Executive Officer of Robeco Group from 2009 to 2015 (EUR 273 billion AUM at end-2015). He also headed Robeco’s subsidiaries RobecoSAM (Sustainable Investing) in Zurich and Harbor Capital Advisors (US multi-manager) in Chicago. From 2005 to 2009 he was a member of the Executive Committee and Chief Investment Officer of ABP and APG All Pensions Group.

 Roderick Munsters will report to Ariane de Rothschild and is part of the Group Executive Committee as Global CEO Asset Management.

“We are very pleased to welcome Roderick Munsters. He will bring a wealth of experience, strong knowledge of international financial markets, entrepreneurial spirit and recognised ability to generate long-term performance” said Ariane de Rothschild, Chairwoman of the Edmond de Rothschild Group Executive Committee.

“I am very pleased and proud to join the Edmond de Rothschild Group and its teams in France and abroad” said Roderick Munsters. “Edmond de Rothschild is a leading reference in Asset Management. The Group is a forerunner of alternative multi-management since 1969, high-yield bonds in the 70s and currency overlay more recently. It is an honour to have the opportunity to take part in the Group’s European and international development and to support the further growth of its reputation”, adds.

 

International Wealth Protection Launches LIFE, Portable Life Insurance

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International Wealth Protection lanza LIFE, seguridad transferible para la vida
CC-BY-SA-2.0, FlickrPhoto: Ron Mader . International Wealth Protection Launches LIFE, Portable Life Insurance

Celebrating 25 years of servicing the international insurance marketplace, Mary Oliva, Founder of International Wealth Protection launches LIFE – Life Insurance For Executives. LIFE is the result of the exponential growth the company has experienced over the last several years and will combine advanced technologies with dedicated protection advisors to empower and service professionals that are seeking affordable and portable life insurance solutions.

“After many years of working closely with the U.S. based trusted advisor of our International clients, we were constantly being approached with inquiries relating to insuring their own lives. Whether it be the client’s financial advisor, attorney or accountant, Executives today are looking for mobility and have expressed concern about limiting their life coverage to the group plans offered by their employer. We found that mostly are under insured and many don’t realize that if they leave their employer their life insurance is not transferrable. With this specific population in mind, I created LIFE tooffer both personalized and automated services. In other words access to experts when you need them and technology when you don’t.” said industry veteran, Mary Oliva.

“I am very proud and enthusiastic about this new offering. As a group, we are now in a position to cater to both our international clients and those professionals that we work so closely with. I know from personal experience that in today’s changing employment landscape, planning at an individual level is integral to meeting your financial goals. Just like we bring peace of mind to our clients, we are now in a position to do the same for our colleagues” said Patricia Carral, Senior Vice President.

This offerwas created exclusively for Senior Executives or those on the path to success. The busy lives of these individuals leave them little time to explore product alternatives that meet their personal financial needs. This launch simplifies this process by providing instant access to Protection Advisors and online services that can assist in implementing the life insurance solution that is appropriate and transferrable. These solutions are all supported by highly rated and globally recognized insurance companies.

 

 

 

Mirage or opportunity in the ‘beta desert’?

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¿Oportunidad o espejismo en el desierto de la ‘beta’?
CC-BY-SA-2.0, FlickrPhoto: Frontriver. Mirage or opportunity in the ‘beta desert’?

High yield bonds were one of the principal beneficiaries of the adoption of quantitative easing (QE) by the US’ and other central banks in response to the global financial crisis. This new wave of monetary policy provided little incentive for savers to deposit cash as long-term interest rates were forced down to unprecedented low levels, unleashing powerful ‘reach for yield’ dynamics as investors searched far and wide for higher returns. This pushed global high yield credit spreads down to lows of 3.6% and absolute yields to 4.9%, in June 2014 (source Bloomberg).

The fallout from the orgy of credit that characterised the run-up to the global financial crisis was mitigated by aggressive central bank policy, which ensured a surprisingly orderly refinancing of the banks’ highly indebted balance sheets. As such, the level of distress was actually quite low compared to earlier cycles and given the scale of the 2008 crisis. In the end, the market reached absurd valuation levels and, with the winding down of the QE programme (‘taper tantrum’), a bear market cycle began to unfold. This was unusual and due to the disconnection between the market and underlying cyclical fundamentals, a direct result of central bank intervention.

The mispricing of an asset normally creates the conditions that lead to a reversal in its fortune, which allows a move back towards its long-term fair value. The post financial crisis bull market in high yield bonds is a particularly good example. Lower quality companies were able to refinance too easily, and, in many cases, took on too much cheap debt, leaving themselves vulnerable to a sustained low growth, low pricing power environment or to material changes in pricing. An example is the shale oil and gas sector which was able to access a seemingly inexhaustible amount of cheap debt at rates wholly incommensurate with the risks. The energy sector made up 9% of the US high yield bond market 10 years ago and rose to become 15% of the market before the oil price began its freefall.

The sell-off in the high yield bond market, partly triggered by the decline in oil prices, undermined confidence in credit markets, and, by extension, growth assets generally. This, in turn, culminated in the cathartic sell-off in January and February 2016 and propelled high yield bonds, formerly so expensive, to what we considered end-of-cycle levels and relatively cheap. Nominal bond yields reached levels in excess of 10% (in the US) and spreads had gone from lows of 335 to 890 basis points (source Bloomberg).

Such levels discounted a rise in default rates to well above 8%, the equivalent of pricing in a recession. Market price behaviour in this episode was typical of how, over the short term, investors can become detached from fundamental reality. This prompted us to re-establish a position from a zero weight across our multi-asset total return strategies, believing as we did that the current low growth, low interest rate cycle has considerably further to run. Having arguably been among the least attractive growth assets, high yield bonds had become the most attractive in the short space of two years.

We re-allocated to high yield bonds sooner than we had originally anticipated. Circumstances presented an opportunity to buy assets at a risk premium, which arguably offered investors the prospect of very attractive risk-adjusted returns over the medium term, even if this featured a relatively severe recession. Furthermore, through careful ‘bottom-up’ selection of individual securities, we were able to lower the prospective default risk of the position, compared with simply owning a passive exposure to the asset class. As long-term investors became aware of the attractiveness of high yield valuations, markets rallied powerfully. High yield spreads have now fallen sharply from 890 to 700 basis points, rendering the case for high yield less compelling, but given the cyclical dynamics, we still regard it as an attractive asset class over the medium term.

Market dislocations and irrational investor behaviour can present excellent opportunities for medium to longer-term investors who focus on fundamentals and valuations. Of course it is not just about recognising the opportunity, but being able to act rapidly and decisively, because windows of opportunity can, as in this case, close rapidly.

Philip Saunders is Co-Head of Multi-assets at Investec.