Wall Street Has No Idea What's Going to Happen to Credit Markets in 2018

Updated on
  • Bearishness at start of year caught out SG, Morgan Stanley
  • Deutsche Bank allows individual team members to make own calls

RBC's Schaffrik Sees Potential for Steeper Yield Curve

It’s the season for investment banks to try to predict the future in credit markets. The ritual is trickier than usual this time.

Rarely have they been so divided by a rally that seems to defy economic gravity -- and those disagreements aren’t just from firm to firm, they’re between strategists on the same team.

“Where we are now is looking for a catalyst for a turning point, which is always challenging,” said Deutsche Bank AG strategist Nick Burns.

The strategists know their year-end outlooks could come back to haunt them. There’s the unpredictable White House and fiscal agenda, and the Federal Reserve and European Central Bank are unwinding or slowing down bond-buying programs. 

Morgan Stanley and Deutsche Bank issued bearish projections at the end of 2016, only to see global corporate and high-yield bonds return 6 percent as the credit rally extended another year.

Societe Generale SA credit strategists Juan Esteban Valencia and Guy Stear also recognized last year’s annual outlook proved too bearish. They had anticipated political risk would hurt credit in 2017, but changed tack by March as that didn’t pan out.

With spreads on U.S. and euro-area corporate bonds close to post-crisis lows -- leaving little margin for error -- the challenge is to acknowledge the positive backdrop while hedging for the downside risks.

Deutsche Bank took the novel approach of publishing the calls of each member of its credit team before positing the house view. Germany’s biggest bank sees a buoyant first half and then a change in the second half, when declining central bank stimulus eventually pressures corporate debt’s tight valuations.

That’s also the view of Societe Generale strategists, who see U.S. investment-grade bond premiums widening by mid-2018, with European counterparts following suit, as credit markets price in the economic slowdown.

"The sword falls in 2H,” according to Valencia and Stear.

Bank of America Merrill Lynch and JPMorgan Chase & Co. see room for the rally to continue, citing ample global liquidity and aggressive risk appetite. Morgan Stanley, HSBC Holdings Plc and Societe Generale, on the other hand, find little to like in a crowded market late in the business cycle.

“There’s a real lack of conviction,” said David Riley, who helps oversee $57 billion of assets as head of credit strategy at BlueBay Asset Management LLP in London.

It’s easy to see why there’s little consensus. Growth is picking up, keeping a lid on corporate defaults and leverage. Yet asset values are “extraordinarily inflated,” according to BlueBay’s Riley, himself a credit bull. And there’s the wildcards of central banks reining in quantitative easing.

“A lot of strategists keep coming back to the issue around valuations but can’t see what would be the catalyst whereby you get a very dramatic or violent repricing given we have this positive global macro outlook,” Riley said.

Cycle End

Geof Marshall, the guardian of $40 billion of assets at CI Investments’ Signature Global Asset Management in Toronto, says this is symptomatic of a peaking business cycle.

“The dispersion of forecasts -- a bit of tightening, a bit of widening -- is consistent with low levels of volatility,” Marshall said. “This worries me.”

Earlier this year, strategists at Bank of America Corp. admitted they “were running out of ideas in credit,” underscoring the challenge of touting high-conviction trading calls after a long and steady rally.

“We certainly didn’t expect it to be as positive as it has been,” analysts at Deutsche Bank wrote in a client note June 13.

BlueBay’s Riley, at least, doesn’t blame strategists if they get their calls wrong.

“Those outlooks have a short shelf life,” he said. “Stuff happens.”

— With assistance by Chris Anstey, and Narae Kim

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