David Oliphant
Executive Director, Fixed Income
In the US, the Trump administration’s imposition of tariffs on imports from trading partners across the world has seen markets plunge. Here is what we are thinking as a credit desk and how we are approaching portfolios
Macro thoughts
- We think the first thing to note is that President Trump’s tariff announcement on Wednesday was well-flagged and diarised – though its effect on risk markets has been pronounced. There were nuances and some surprises contained in the treatment of various countries, but in aggregate this has been a theme playing out for at least this year, if not longer. Much of the large divergence we have seen in and between markets this year – including in government bonds, credit, equities, FX and so on – has come from the fear of trade tariffs and from the US’s economic, political and military relationships with other areas of the world.
- One would have to assume higher tariffs means higher inflation – in one of the greatest challenges to globalisation seen in decades. All else being equal, higher inflation offers less ‘wiggle room’ to reduce interest rates for central banks – hence tighter monetary policy than might have been hoped for. The uncertainty of tariffs and the threat of an expanding trade war will also be less supportive for growth.
- Companies will have less confidence to embark on capital expenditure and investment and be more reluctant to hire labour or make other such long-term plans. Some of this can be seen already in consumer and corporate confidence economic barometers, such as the Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI). Markets had already priced some of this.
- When we look at consensus estimates of growth and inflation for the US, Europe and the UK, growth estimates have been reduced and inflation expectations have risen. Indeed, short-term measures of inflation expectations are the highest they have been for a couple of years in the US. We note that Deutsche Bank Research reduced its forecast for growth in the US this year from 2.2% to less than 1%, while it expects inflation to rise from 2.7% to 4%. Other investment bank forecasts followed suit over the weekend.
Credit thoughts
- For credit markets, higher (than previously imagined) interest rates are likely to be a negative factor for spreads, with lower growth and the risk of recession a less positive, if not negative, environment – especially for more levered and cyclical businesses. More restrictive monetary policy and lower growth would have been easier to digest were valuations or spreads attractive. But that is not the case. Spreads in both investment grade and high yield trade tight to both shorter-term (five-year) and longer-term (20-year) averages. It is worth noting that spreads have widened by 28% for IG and 40% for global HY so far this year, according to data from ICE Indices. Yields remain elevated, however, and this has attracted (and will probably continue to do so) interest for income-seeking investors and kept ‘a lid’ on spreads.
- We have viewed this environment as one in which the rewards for taking higher levels of credit risk are relatively low. Therefore it is a time for defensive portfolio construction. Consequently, we have run relatively low levels of aggregate credit risk (beta) compared to periods where, although risks might have appeared high, spreads offered a more compelling reward for taking such risk (for example, mid-2020). Hence, we have biased portfolios towards sectors that would be more resilient in this type of uncertain/tight spread environment, including utilities, telecoms and healthcare in IG, and are running levels of credit risk that have been reduced in the past year or so.
- The outlook for trade, tariffs and the economy remains very uncertain and is open to substantial change at short notice. Questions remain about the likely response from trade partners (for example, China has already responded with 34% blanket tariff on US goods, and the European Union is in the process of drafting a response), as well as the fiscal response from the US and other countries.
- In our risk budgets we limit the amount of risk we take in the less predictable, less repeatable sources of performance such as duration management (small) and FX management (none at all). Instead, we focus on sources of performance that are most likely to yield success – issuer and security selection – and we will continue to do this.
