- There will be blood...and more of my favorite themes for 2016. California’s early 20th century oil boom depicted in the 2007 film provides this year’s lead theme highlighting the risk outlook: collapsing commodity prices’ risk of spillover into the broader outlook. Certainly, there is already blood in the energy sector. Compared to the prior year, commodity sectors in 2015 saw a quadrupling of defaults. Though much of these risks are priced into credit spreads, the prospects of even further erosion keep us cautious on credit for 2016.
- The credit cycle leads the business cycle. Heard this one before? “As we see no signs of recession…” the advice states invariably to “keep on dancing.” But you never see the recession coming—it’s always a surprise. And that generally is because you are looking for its signs in all the wrong places. Using economic forecasting to predict the credit cycle gets it backwards because the credit cycle predicts the business cycle, not the other way around. Unique for this cycle, the Federal Reserve’s reliance on the “Portfolio Balance Channel” increases the macro vulnerabilities.
- Promises, promises. The Fed promises “only gradual increases” in the federal funds rate and the market believes an even more gradual path than most Federal Open Market Committee members project. As the song refrain asks, “why do I believe?” Conditional on its forecasts for economic conditions, the Fed promises a “gradual” normalization. But the Fed has been a poor forecaster. Two-sided risks to the Fed’s outlook lie in faster-than-expected wage growth signaling an even tighter labor market or oil’s spillover effects halting normalization.
- Preference for preferred. In what is an otherwise defensive strategy for 2016, what do we like? Though also vulnerable to a general risk off and especially an equity market correction, we prefer to take our higher risk income allocations by going down the capital structure of higher quality names.
- And more of my favorite themes. Non-USD bonds look better positioned vs. last year given the significant repricing of the dollar and move to neutral from underweight. Treasury Inflation-Protected Securities’ (TIPS) valuations look attractive but near-term headline commodity inflation risk keeps us neutral. Downside risks plus a very gradual Fed improve the attractiveness of gold. And the back end of U.S. duration looks preferable given Fed normalization and deflationary tail risks. The U.S. consumer, residential and commercial real estate sectors stand far removed from the epicenter of this credit cycle, leaving their mid- and higher-quality securitized exposures a good source of carry, but we limit their allocations due to their relative illiquidity. Finally, we see the outlook for stocks vs. bonds more balanced than in prior years given extended stock valuations and the significant repricing of risk in bonds.