The fourth quarter of 2018 is starting to look like a distant dream for the US high yield market. In the first three weeks of this year the US HY Index (B1-rated) has produced a year-to-date total return of 3.98%, while the equivalent CCC-rated index has delivered a YTD return of 5.63%.
Unfortunately, Q4 certainly wasn’t a dream and so this begs the question: how did we recover so quickly from what was the worst sell-off in credit markets since the financial crisis?
First, the year began on a positive note after dovish comments from the Federal Reserve chair, Jerome Powell, on January 4 laid to rest some fears emanating from the marketplace of a potential policy mistake from the US central bank. Powell stressed the Fed’s policy stance would be data dependent rather than relying on dot plot schematics (which at times have given the impression of Fed policy direction etched in stone), and the market took comfort in this much needed clarification.
Second, the Fed has recognized that not only are there current global growth concerns, but plenty on the horizon as well. As a result it has indicated it will exercise patience in any future policy rate decisions. This was a welcome reprieve for the market, given the Fed had been noticeably hawkish in tone towards the end of 2018 given strong US economic data.
Third, investors were holding too much risk towards the end of last year and the sell-off was as much a matter of liquidity as it was concern of a policy mistake. Technically, the market was ripe for a rebound.
Finally, markets have reacted favourably to signs of a more positive outcome in the US-China trade talks. Although there are still hurdles to overcome, particularly in matters of cyber security, ongoing talks are showing positive momentum and China’s recent statement that it is willing to reduce its trade deficit with the US over a period of six years is a breakthrough.
The effect of all this positive news has been seen in the primary US high yield market, which after a slow start has seen a healthy calendar over the past week, with over $6bn printed in a series of heavily subscribed deals. It is worth pointing out that we didn’t have a single high yield transaction in December and pent up demand is certainly a factor, but this should not detract from the healthy performance and attractive pricing of the recent transactions.
We are still not out of the woods, as conflicting non-farm payrolls data and manufacturing ISM reports clearly showed us at the beginning of the year. Data dependency is the key and investors need more clarity. As such, we are certain to see more volatility, both in US high yield and other markets.
In short, we feel further impetus is needed for this rally to push on. This might come in the form of a bounce back US manufacturing data (which worried markets with a material drop in January), substantial progress in the trade talks, or even a welcome end to the US government shutdown. Should this not be forthcoming, we sense the rally could run out of steam with investors’ focus returning to the upcoming earnings season for guidance.
Given this outlook, we continue to favour shorter-dated, higher-quality bonds with a view to having more certainty over principal returns, while remaining liquid and nimble to take advantage of opportunities that present themselves.