This week saw a further flight to quality rally with ten-year US Treasury yields dropping 8 basis points to 2.04% as yet more weak US data and falling oil prices kept risk assets under pressure. US high yield saw prices decline by 2.5% over the week with spreads widening by 65bps to +779 bps over, which is a big move even by the standards of high yield. Global equities continued their difficult start to the year with the Dow down 8.25% as at Friday’s close.
Last week we highlighted our concerns about global growth and this week’s US data provided little reason to become more optimistic. Although the Empire Manufacturing Index has a history of high volatility, the drop in this index to minus 19.4 was well below expectations. Although we last reached this level in early 2009, this was during a period of recovery from the lows of the prior year. If we look at periods where growth was slowing, we have to go back to October 2008, when the US economy had already been in recession for nine months. The Atlanta Fed’s GDPNow forecast has dropped to just 0.6%. Bear in mind also that this is a forecast for Q4 2015, so it is somewhat backward looking although more timely than the GDP data itself.
The decline in oil prices is also shifting inflationary expectations. Futures on the CME dropped from 33.16 to 29.42 over the course of the week which equates to a drop of 11.3%! Such sharp falls in oil prices, and commodities generally, are likely to cause numerous defaults in the US high yield market over the coming months. Falls in the oil price are also forcing governments reliant on oil revenues to review and revise their budget estimates and target further expenditure cuts. Russia remains prudent announcing a further RUB 700bn of cuts (~10%) targeting state investments and administrative expenses. The potential privatisation of some state assets is also under consideration. Details are still emerging but this prudent approach is credit positive.
Russia is less constrained than some governments as the exchange rate can adjust to offset some of the weakness in oil prices and keep the balance of payments in surplus. Plus it has sizeable reserves and sovereign wealth funds it can tap into. However, even so with Brent crude prices now languishing in the low $30s further cuts are needed to keep the fiscal deficit from exceeding 3 percent of GDP.
Whilst even high quality investment grade bonds are currently seeing price declines, albeit more modest than seen in the junk bond space, the continued rally in US Treasuries is presenting some extraordinary value. For example Abu Dhabi’s sovereign wealth fund IPIC (Aa2/AA) has seen the spread on the 2041’s widen to +261bps. Spanish government bonds (Baa2/BBB+) of the same maturity have a YIELD of only 2.85% so at some point, if government bonds continue to rally as we expect, investors will look for alternatives. AA bonds like IPIC 41’s with a yield of 5.25% seem much better value to us than the debt of a heavily indebted government rated several notches lower.