GLOBAL WEEKLY COMMENTARY

Credit is less compelling

Oct 23, 2017

Key points

  • We are downgrading U.S. credit to neutral given our outlook for less upside and more downside potential. We prefer taking risk in equities.
  • Prime Minister Shinzo Abe’s party scored a solid victory in Japan's general election. Spain took steps to remove the Catalan government.
  • The European Central Bank is expected to announce an extension to its bond buying program’s length well into 2018 and a reduction in its pace.

We are downgrading U.S. credit to neutral from overweight as its outlook has become less compelling lately. We see better prospects for equities in an environment of steady economic expansion, easy financial conditions and strong corporate earnings.

Corporate yield spreads relative to U.S. government bonds, 2000-2017

Chart: Corporate yield spreads relative to U.S. government bonds, 2000-2017

Sources: BlackRock Investment Institute, with data from Bloomberg Barclays, October 2017.
Notes: U.S. high yield is represented by the Bloomberg Barclays U.S. Corporate High Yield Index and U.S. investment grade by the Bloomberg Barclays U.S. Aggregate Corporate Index. Spreads are measured in percentage points and are option adjusted spreads, a gauge used to measure the excess yield (across all maturities) that investors demand from investing in credit versus U.S. government bonds.

Credit spreads have tightened globally as investors’ search for yield has driven prices up and rates to historical lows. U.S. credit spreads relative to government bonds are now at the narrow end of their 17-year range, as the chart above shows. When credit spreads are this tight, even a relatively small sell-off can wipe out the income advantage of credit over government bonds. Our revised view on U.S. credit follows our downgrade of European credit in April. Both markets’ narrow spreads and low yields leave little room for more spread tightening as interest rates gradually rise.

Limited upside ahead

The sustained global economic expansion and an outlook for gradual monetary policy normalization – with inflation moving slowly back toward trend in the U.S. – make for a positive backdrop for risk assets. Yet we believe equities offer a better risk-reward profile than credit given their potential for greater upside in returns and more balanced downside risks. At tight levels of spreads (or high bond prices), the risk profile of credit tends to be asymmetric: limited return upside, with significant potential downside. This is because the return on a corporate bond held to maturity is limited to its yield, while the potential downside is much greater in the case of default. Tight yield spreads on U.S. high yield bonds today reflect the current benign environment for defaults. This leaves little safety cushion against risks either from rising interest rates or any increase in default risk. Bottom line: Credit has little further price upside in the case of ongoing economic growth and strong equity markets, but plenty of downside risk in a growth slowdown and equity market sell-off.

Credit quality has also long been eroding in some pockets of the credit market, with the thirst for yield leading to a more favorable environment for issuers at the expense of lenders. For example, the quality of the covenants protecting lenders has been declining for some time and “add-backs” – which allow issuers to inflate some measures of earnings and thus creditworthiness – are on the rise. Also, BlackRock’s proprietary market positioning gauge – which includes fund flow data and measures of price momentum – shows positioning in the U.S. credit market at relatively hot levels, versus a more neutral stance in U.S. equities compared with recent history. Overall, this argues for taking risk in equities over credit. Within credit, however, we prefer up-in-quality exposures and favor the U.S. over Europe, where richer valuations mean lower income potential and higher sensitivity to interest rates. We expect rates to move gradually higher globally, so we have an underweight stance on duration, but see long-term government bonds as useful portfolio diversifiers.

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Date:Event
Oct. 24 Japan Nikkei Flash Manufacturing Purchasing Mangers’ Index (PMI); Germany, eurozone and U.S. Markit Flash PMIs
Oct. 25 UK Q3 GDP
Oct. 26 European Central Bank (ECB) monetary policy meeting and press conference
Oct. 27 U.S. Q3 GDP, Q3 core personal consumption expenditures

The ECB is expected to extend its bond-buying program’s length well into 2018 and reduce its pace. This is the busiest week of U.S. third-quarter earnings season. Earnings reporting gets underway in Japan and in Europe, where a strong euro is expected to be a drag.

  • Prime Minister Shinzo Abe’s party scored a solid victory in Japan's general election, likely extending the lifespan of "Abenomics," including the Bank of Japan's mega stimulus.
  • President Xi Jinping outlined a vision of consolidated power at the China Party Congress. China’s third-quarter gross domestic product (GDP) growth cooled from the prior quarter as expected, and inflation data were mixed. China’s central bank governor warned against excessive optimism fueling a “Minsky Moment” sudden collapse in asset prices.
  • North American Free Trade Agreement fourth-round renegotiations ended, with Mexico and Canada rejecting what they see as harsh U.S. proposals. Spain took steps to remove the Catalan government and organize regional elections.

Global snapshot

Weekly and 12-month performance of selected assets

 

EquitiesWeekYTD12 MonthsDiv. Yield
U.S. Large Caps 0.9% 15.0% 20.3% 1.9%
U.S. Small Caps 0.5% 12.4% 25.4% 1.2%
Non-U.S. World -0.4% 23.3% 22.4% 2.9%
Non-U.S. Developed -0.3% 21.5% 22.1% 3.1%
Japan 0.2% 17.6% 16.5% 2.0%
Emerging -0.5% 32.3% 25.4% 2.4%
Asia ex-Japan -0.1% 36.3% 27.6% 2.3%
BondsWeekYTD12 MonthsYield
U.S. Treasuries -0.5% 2.0% -1.2% 2.4%
U.S. TIPS -0.6% 1.6% -0.7% 2.6%
U.S. Investment Grade -0.4% 5.3% 2.5% 3.2%
U.S. High Yield 0.3% 7.5% 8.2% 5.3%
U.S. Municipals 0.1% 5.2% 2.4% 2.2%
Non-U.S. Developed -0.9% 8.3% 0.6% 0.8%
Emerging Market $ Bonds 0.0% 9.4% 5.5% 5.2%
CommoditiesWeekYTD12 MonthsLevel
Brent Crude Oil 1.0% 1.6% 12.4% $57.75
Gold -1.8% 11.6% 1.2% $1,280
Copper 1.0% 25.6% 49.4% $6,952
CurrenciesWeekYTD12 MonthsLevel
Euro/USD -0.3% 12.0% 7.8% 1.18
USD/Yen 1.5% -2.9% 9.2% 113.52
Pound/USD -0.7% 6.9% 7.6% 1.32

Source: Bloomberg. As of October 20, 2017
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Table: Asset class views from a U.S. dollar perspective

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Richard Turnill
Global Chief Investment Strategist
Richard Turnill, Managing Director, is Global Chief Investment Strategist for BlackRock, leading the Investment Strategy Function within the BlackRock ...
Isabelle Mateos y Lago
Global Macro Strategist, BlackRock Investment Institute
Isabelle Mateos y Lago, Managing Director, is BlackRock's Chief Multi-Asset Strategist. As part of the BlackRock Investment Institute (BII), she is responsible ...
Kate Moore
Chief Equity Strategist
Kate Moore, Managing Director, is Chief Equity Strategist for BlackRock and is a member of the BlackRock Investment Institute (BII). She is responsible for ...
Jeffrey Rosenberg
Chief Fixed Income Strategist
Jeffrey Rosenberg, CFA, Managing Director, is BlackRock's Chief Fixed Income Strategist and a member of the BlackRock Investment Institute. His responsibilities ...