Maneuvering in a more volatile world

Executive Summary

The global equity markets have recently been battered by concerns over global economic growth induced by a slowdown in China. The People’s Bank of China (PBoC) policy decisions surrounding devaluing the Yuan and propping up the equity market have come under scrutiny at a time when the Chinese economy is transitioning from an investment oriented fixed-asset economy to one which is much more consumer-led. As a result, the Shanghai Composite Index is down 40% from its peak in June 2015. The commodities market is in a state of supply glut as a result of China moving from a commodity importer to an exporter.

Recently, a key metric for China’s manufacturing activity showed the lowest level in 77 months; steel production and consumption was down significantly. For example, the supply of steel in China has outpaced demand, impacting the price of iron ore, the key ingredient in steel making. The price of iron ore has fallen from $190 a metric ton in 2011 to roughly $50 a ton currently, squeezing profits for the world’s largest mining companies. The Commodities and Energy industries have been hit particularly hard as the dependence on China’s demand to support an oversupply of inventories across various commodities and oil gets tested.

While the global equity markets have shown a significant increase in volatility, the credit markets have been relatively stable. U.S. economic growth for the second quarter was well above expectations of 3.2% at 3.7%, and European economic growth has been gradually improving from a low base. Default rates in the global high yield market are expected to stay below 3% over the next 12 months, well below the long-term average of nearly 5%. A U.S. potential Federal Funds rate increase in September is causing some market anxiety given the recent fragility of the global equity markets, and a possible rate increase on September 17th would be expected to further amplify volatility.

With this report we intend to provide some perspective and outlook on both the global high yield and investment grade markets. While the high yield market tends to get painted with the Energy sector brush, the vast majority of the market is fundamentally sound with most industries having low default probabilities and positive returns over the past 12 months. In global investment grade, one of the main risks has been the record number of M&A transactions and the resulting leverage through the large amounts of corporate bond supply. However, positioning the portfolio with a higher allocation to Banking, which is not as M&A prone and has become a highly regulated industry, can provide a degree of protection from the M&A wave. In sum, while there are regional risks such as China, industry risks such as Energy, and issuer specific risks tied to M&A activity in the global credit markets today, an active portfolio manager may find plenty of opportunities in bonds with strong fundamentals if volatility increases.