Relative to recent weeks, markets last week were a little more calm but don’t be fooled into thinking this period of volatility is done.
As we step back and assess what has happened, the American administration essentially picking a trade fight with the world, we should take a pause. Yes, the US is a superpower, but at less than 5% of the world's population, they can’t do everything…and this is the problem; one could argue that the administration thinks they can.
We are still working through the impact of tariffs on our global high yield portfolio. Thankfully as bond investors we just have to answer the question; ‘am I getting my money back?’ – a somewhat easier task than ‘what is this company worth?’…
As we try and navigate the path of returns from here, we can’t help but notice some of the oddities of the tariff policies. Do the US want to manufacture their own goods? Yes.
Do they really want to manufacture t-shirts and trainers? Perhaps, although with a tight labour market, this could be a challenge. Tariffs are a good way to incentivise local production and the market is telling us that.
Imposing tariffs on Botswana of 37% because they export diamonds? It doesn’t take a science major to figure out that diamonds can’t be manufactured, and this is where the US has clumsily overstepped the mark.
As the US administration engages in individual tariff negotiations (with the UK and Japan likely first), we may see some cooler heads and a recognition that selective tariffs are perhaps more useful than universal ones.
However, do we think the elephant fight between the US and China will go away? Quite simply, no and this will lead naturally to a greater risk premia.
Where does that leave us in high yield? Spreads have widened around 150bps from February this year. We are still inside long-term averages on spread but are above long-term yield averages.
The asset class is effectively flat year to date despite the widening, which pays testament to the fact that high yield has lower volatility than equities and also where income drives asset class returns far more than capital prices does (the inverse to equity markets which are price led).
Of course when looking for an entry point we do think about capital prices. From here it’s clear that the world has changed to one which will likely see some retraction in globalisation and naturally with it this will bring about some higher inflation.
Despite this, it’s important to keep in mind what risk-free rates will do. Central bankers have the unenviable task of managing both growth and inflation and should animal spirits dissipate then central bankers will have little option but to cut interest rates. The market is pricing in around four cuts from the Fed this year for example.
While this might lead to further spread widening, there is also no guarantee that it will lead to lower high yield bond prices (if all in yields fall from their current levels).
While predicting the path of future spreads is impossible, we aren’t anticipating a return to previous levels anytime soon. We don’t however expect all in yields to rise significantly.
If they do, the asset class currently has a breakeven of 2.75% (i.e. an entry point today can afford yields to rise by this amount to around 11% before losses are incurred on a one-year holding basis), so definitely some margin for error should all in yields rise.
Despite the current calm, markets will remain volatile and are likely to remain just as unpredictable as the politics that are driving them. We would advocate that high yield is where the certainty of coupon/income-based returns can offer some comfort in a world of uncertainty.
Mark Benbow is co-manager, of the Aegon High Yield and High Yield Global funds. The views expressed above should not be taken as investment advice.