It is almost autumn, the season for the Sweet Autumn Clematis, a white-flowered vine much loved by bees due to its sweet aroma (hence the name). Just like bees attracted to the clematis, we are finding the climate for developed market corporate bonds particularly sweet.
Currently, companies have again started shoring up their balance sheets with cash, following much better than expected results during the second quarter. The better results also coincided with more positive revisions in one-year forward earnings expectations. We see this as evidence that we have started transitioning through the cycle faster than anticipated with the recovery stage likely to be reached by the turn of the year. The recovery stage should mature sometime later in 2021 with EBITDA and cash flow generation recovering almost naturally and more rapidly than anticipated. We can look through the macro weakness that Covid-19 has caused, thanks to adaptation by businesses and individuals that have set the stage to return to business, avoiding further lockdowns. The fiscal packages that are worth about 10% of GDP in both the US and European Area should ensure a V-shaped or Swoosh-like recovery and a return to pre-Covid levels by Q4 2021 at the latest, in our view. We also note that capital expenditure intentions or capex intentions have continued to move upward this summer and this is another good indication that we should soon shift from repair and into recovery.
The developed market economies should also benefit from continued monetary support even as they recover with good coordination amongst policymakers. What happened at Jackson Hole last month is of immense importance for the low rates environment (addressed below) and should ensure that that the recovery takes hold. The recovery stage is generally the sweet spot for credit and credit spreads as corporates further increase cash flows, act for the benefit of bondholders and, in the end, reduce leverage. During such a stage, spreads typically further grind tighter and we anticipate mid-yield spreads to continue to narrow further as they are not yet back to pre-crisis levels. The shifting drivers of market cycles from the repair stage are generally very supportive for developed market corporates making the recovery sweet indeed, for those investors who choose to take part in it.
Onto the US Federal Reserve. At the Jackson Hole symposium, Chairman Jay Powell delivered revisions to the “Longer Run Goals” that were extremely dovish and likely to support the recovery. This year’s symposium confirmed that the Fed is worried about the lack of inflation.
You may remember that last year Mr. Powell introduced the 3 Eras of Monetary Policy in his speech, but lacked a label for the third era, starting in 2010. We suggested the term “Missingflation”, which is all the more appropriate today.
Indeed, at this years’ symposium, the Fed announced that it is pivoting its inflation strategy from a 2% forward-looking symmetric inflation target to targeting 2% inflation on “average over time”. The Fed believes that this will better articulate their inflation goal and will support better economic growth and job creation. Their pursuit of average inflation at 2% means that the Fed plans to keep interest rates at zero until inflation reaches on average 2% and is sustained at that level for quite some years. Looking back at the past, their projections for “personal consumption expenditures inflation” had been below 2% since 2012, and one can imagine that the Fed will refrain from raising interest rates for quite some time, even if inflation overshoots above 2% for some years. By our count, there may not be any interest rate hikes forthcoming, thus keeping rates at the effective lower bound or zero in the US until 2024. This assumes that the recovery plateaus from 2022 with the Fed allowing inflation to overshoot above 2% for a couple of years to ensure that it is sustainable. Their notion of average inflation would allow for that now, especially as their inflation projections experienced periods of persistent undershoot since 2012.
These Fed developments are extremely positive for sentiment in developed corporate bond markets as they should support recovery as it unfolds, in our view. It will also encourage investors to increase their credit allocations as their mindset should move from perhaps doubting the recovery, to embracing it. The release of a successful vaccine for Covid-19 could provide an additional sentiment boost, thus boosting demand for credit. The hunt for yield should be renewed in a context of “lower forever” rates and an environment where fundamental credit risks are peaking.
The recovery is about credit improvements and lower credit risk has started manifesting itself with credit rating changes stabilizing on the back of mitigating measures such as lower dividend payments, paused share buybacks, reduced M&A, as well as renewed cash flow generation.
While bees use the Sweet Autumn Clematis to produce honey, we believe investors can use the sweet spot in developed market mid-yield bonds to produce returns.