IMF Growth Outlook May Re-Ignite Credit Bubble Concern: Analysis

Central Bank monetary policy accommodation, in response to global economic weakness, has been the bedrock of positive risk-asset price performance in recent years. But in the continued absence of a meaningful pickup in global growth, it may soon be difficult to reconcile robust risk-asset valuations with the anaemic nature of underlying macroeconomic fundamentals, Bloomberg strategist Simon Ballard writes.

In its latest World Economic Outlook, the International Monetary Fund (IMF) says that while growth in emerging market regions and in developing economies is still seen as being among the key drivers of global macroeconomic expansion in 2016, the prospects for economic growth across individual countries remain uneven and generally weaker than over the past two decades. Meanwhile, gains in advanced economies are forecast to remain modest.

This cautious IMF macro view may now fuel questions about a possible valuation bubble forming in speculative-grade corporate bonds. Indeed, it may be increasingly difficult to justify the current tight level of risk-asset valuations, as well as the degree to which yield spreads are now compressed, simply on the basis of low interest rates alone. Data from Standard & Poor's already shows that the U.S. trailing-12-month speculative-grade corporate default rate widened to 3.8 percent in March -- the highest rate since 2010 -- and that the rate is expected to hit 3.9 percent by the end of this year.

The sharp decline in the yield structure has created significant challenges for risk asset investors seeking to maximise returns
The sharp decline in the yield structure has created significant challenges for risk asset investors seeking to maximise returns

Moreover, investor concerns could be exacerbated should a more hawkish outlook begin to be factored into U.S. Federal Reserve monetary policy assumptions over the course of 2016 and 2017. In a rising interest rate scenario, speculative-grade risk positions may be most susceptible to the implied increase in interest costs over time, which in turn could create significant uncertainty among investors. On the flip side, a more dovish outlook for European Central Bank monetary policy relative to that of the Federal Reserve over the coming months, may help to drive the outperformance of, and investor preference for, Euro-denominated risk assets relative to USD credit risk, even though the broad weak macroeconomic outlook will likely favor up-in-quality investment strategies in both currency brackets.

Central bank monetary stimulus and open-ended liquidity can only justify tight corporate spreads over the longer term if economic growth and corporate profitability flourish, an outlook that the IMF report suggests may now be in doubt.

The current low interest-rate environment, which has existed since the global financial crisis, has encouraged investors to stretch into higher-yielding, higher-risk assets in order to maximize their investment returns. The yield spread differential between a risk asset and its underlying government bond benchmark is supposed to be an indicator of the implied default risk in the investment; the wider the spread, the greater is the compensation an investor receives for accepting a heightened level of default risk in the portfolio. However, while loose monetary policy can facilitate corporate funding, minimize default risk and drive credit spreads and yields lower in the near-term, prolonged weak economic conditions may eventually risk eroding corporate earnings, credit quality and, by extension, the corporate default-rate outlook.

Note: Simon Ballard is a credit strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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