FEBRUARY 2014
LEGAL & GENERAL INVESTMENT MANAGEMENT
Fixed Income Focus.
Worried that no one else is worried
US weather has been awful in recent weeks, undoubtedly impacting
economic activity as shoppers stayed indoors and workers struggled to
get to offices. Could the weather be masking something more serious?
Markets have shrugged off the recent spell of poor economic data, happy to
look forward to sunnier times to come. This reaction may turn out to be the
correct one, but it does seem to dismiss non-weather related concerns that are
bubbling under the surface.
Contribution by Ben Bennett –
Credit Strategist
Ben focuses on allocation within the
credit funds as well as providing the
credit input to macro strategies.
He joined LGIM in May 2008, having
spent the previous three years at
Lehman as a Director within the
bank’s credit strategy function.
Ben has 14 years of experience
within credit strategy. He holds an
MA in Mathematics from Queens’
College, Cambridge University,
graduating in 1999.
It was noticeable that US data started to deteriorate before the weather turned
really bad, and there were already signs of companies building inventories in
the fourth quarter, suggesting that demand wasn’t keeping up with production.
The weather impact on Q1 2014 US GDP has led to investment banks slashing
their growth estimates, but Q4 2013 GDP may also get revised down quite
sharply. In addition, it hasn’t just been the US that appears to be suffering a
soft patch. In Asia for example, Chinese manufacturing confidence is slowing
as authorities struggle to deal with defaulting financial products, and question
marks are appearing about the success of Abenomics with disappointing wage
and trade data out of Japan.
Away from China, there have of course been broader problems within
emerging markets, with political unrest in Ukraine (with the deposing of
President Yanukovych unlikely to see an end to uncertainty) and Thailand
together with significant currency volatility in Turkey, South Africa and Brazil.
Europe is doing better, with upside surprises to GDP and steadily improving
manufacturing sentiment, but this is coming from a very low level.
Moreover, while US monetary policy has been a source of market support for
some time now, the Federal Reserve is adamant that they will gradually wind
down their programme of bond buying in the coming months. And yet markets
have remained remarkably resilient, with equities recovering from their January
nervousness and credit spread premia back down to recent low levels.
The only sensible explanation is that investors are not only convinced that US
economic data will rebound once temperatures rise, but they also expect other
sources of volatility to gradually subside. Such a constructive outlook is certainly
aided by the technical support for corporate bonds, with new bond issues
currently meeting strong demand, even during weaker days for the broader
market, thanks to a steady inflow of cash to the markets. This seems particularly
prevalent in the US, with longer-dated corporate bonds supported by pension
fund demand, but the European bond markets also appear to be underpinned.
FEBRUARY 2014
LEGAL & GENERAL INVESTMENT MANAGEMENT
02
Figure 1: Credit spread premium remains low despite disappointing economic data
90
-20
85
0
80
20
75
40
70
60
65
80
Nov-13
Dec-13
European Credit Spreads (iTraxx Europe, bp)
Jan-14
Feb-14
Citi's US Economic Data Surprise Index (RHS, inv)
Source: LGIM, Citi, Bloomberg L.P.
While the optimists could well be proved right, it often pays
to consider alternate scenarios. In this case, this could mean
that bad weather is just a convenient excuse for underlying
economic weakness. Forward looking comments during
recent company earnings calls do not signal a widespread
appetite for investment and hiring, so what is going to
trigger this improvement in animal spirits? If anything,
corporate enthusiasm will be tempered by recent emerging
market weakness, which has long-since been the focus
of corporate expansion strategies. Ubiquitous investor
optimism and valuations back at the recent peaks suggest
that markets could fall a reasonable amount if the weather
excuse is found wanting.
Either way, we retain our cautious longer-term view for
credit. There are risks to both sides of a perfect scenario
of credit spreads grinding lower as monetary policy is
successfully withdrawn and economic activity gradually
expands. Either the withdrawal of supportive policy (e.g.
the Fed’s quantitative easing) is not successfully managed,
leading to yield volatility and pressurising bond markets in
general, or growth could relapse (triggered by, for example,
an increase in EM volatility), leading to credit market
weakness. Current tight valuations amid widespread belief
in the perfect scenario amplify our concerns.
In the short term, we believe that even those with an
optimistic short-term outlook should be treading carefully.
When all the market experts immediately look to explain
away consistently bad news, this is usually the time to be
most sceptical.
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