Last week my colleague Erik Knutzen wrote about today’s “show-me-the-money” markets. It’s an important element in our current thinking so I am going to expand on it a little here. But I also want to examine why the very mixed fundamental data we have been seeing, which may not appear to support the recent rally in risk assets, may also be favorable for fixed income credit.
The improvement in sentiment since mid-February, when it looked like the perfect storm was descending on financial markets, has been huge. But is it justified by better fundamental data? That’s not obvious—when you add up the news flow on growth, profits, central bank policy, global production, consumption and jobs, you end up with a pretty mixed bag. A lot of the re-pricing of risk since mid-February was fuelled simply by improved sentiment. We managed to sail around the worst of the storm.
So the big question now is whether the economy can sustain that with a significant improvement in corporate cash flows, earnings and profits: “Show me the money!”
We are cautiously optimistic because we believe the conditions for these improvements are relatively easily met and may already be evident. Four months ago when we took a step back to review 2015, two big themes stood out: We could see that better earnings in the second half of this year would likely result if the dollar stopped going up and oil stopped going down. In our view, it is no coincidence that U.S. corporate cash flow peaked in the second quarter of 2014, when oil was north of $100 per barrel and the dollar was 20% cheaper than today, but both were about to embark on enormous trends. Arrest those two trends and you likely stop much of the rot in both U.S. high-yield cash flows and U.S large-cap earnings. In our view, stable oil prices should relieve the drag the energy sector is exerting on S&P 500 profit margins. Normally a sector that generates above-average profits, the current gap between its margins and those of the rest of the index has never been bigger.
This is why the dollar cheapening by 5% and oil settling above $35 per barrel is a big deal for corporate earnings in the latter half of this year. Combine that with the base effect of coming off a terrible year for profits, and the fact that things have moved so fast that analysts’ assumptions probably haven’t yet taken all this into account, and the coming months could deliver some notable positive surprises in cash flows and earnings.
How do we make the moves we are seeing in U.S. Treasuries fit this thesis? Yields have been falling since mid-March, and some might see that as bond market skepticism about the scenario priced into risky assets.
We don’t think that is the case. There are negative central bank rates in Europe and Japan, and the potential of another summer flare-up of the Greek debt problem is pushing core Eurozone yields ever lower. It would have been impossible for U.S. Treasury yields to escape that gravitational pull even if the Federal Reserve had not become more explicit about the influence of global factors on its policymaking and moved its rate-hike projections substantially lower in March. If U.S. rates do not seem to be in line with U.S. fundamentals at the moment, the more complete explanation is that they are in line with global fundamentals.
Bring all of this together and we think you create a very interesting environment for fixed income credit. These assets eventually enjoyed one of their best quarters for five years in the first quarter, because a mixed bag of data drove rates down and credit spreads tighter—a combination that we haven’t seen much of lately. A similar combination of improving U.S. earnings and the continued gravitational pull of global rates on U.S. Treasuries yields could extend those conditions further into 2016. The contrast with where we were at the beginning of this year, when the Fed looked set to hike rates against a backdrop of faltering global growth, couldn’t be starker.
That is why we are cautiously constructive on risk today. And if the economy starts to show us the money over the next few months, we may be ready to lift some of that caution.