GAM STAR CREDIT OPPORTUNITIES : OUTLOOK FOR 2018

It is the season of providing views and opinions for 2018 and you will have received many, so in this note we will focus on those that matter for our strategy. We invest mainly in investment-grade companies, buying their junior debt to capture coupon income flow. Of prime importance for us are the factors that affect a company’s ability to remain healthy from a credit point of view, enabling them to pay us our coupons and our money back; and also those factors which can affect prices in the short term.

Growth
Looking ahead to 2018, many of the macro drivers for 2017 seem set to continue. Europe, where most of our investments are, looks attractive given gently improving domestic consumption and growth. Steady and positive growth is favourable for credit metrics.
 
Inflation and interest rates
Inflation has so far been contained both in the US and in Europe, but we are keeping a close eye on labour market metrics. While there is little wage pressure in mainland Europe, in the UK and US the labour markets have become tighter and we would expect some gentle upward pressure on inflation. Whether or not this translates into sustained higher inflation, we expect that central banks, which have already started normalising interest rates, will continue to do so, but only gently. We foresee no reason for central banks to be aggressive on rate rises. Much has been written about the fact that at these unemployment levels the Phillips curve would predict higher inflation. However, since the global financial crisis, we observe that the Phillips curve has been much flatter than for the 40 years before 2008, so a rise in employment has had a much more muted impact on inflation. Whether this is because of new technology, globalisation, lower inflationary expectations or a shifting supply curve, or more probably for all of these reasons put together and more, we expect inflation to remain subdued.
 
It is useful to remind ourselves that interest rates are not the only factor affecting bond prices: for example the financial sector is one whose profitability tends to rise when rates go up and this can increase its attractiveness, counterbalancing some of the price impact of rate rises.
 
As far as these themes do affect the general bond market in the short term, those who know our strategy are aware we aim to have a low sensitivity to interest rates by currently having about half in fixed-rate bonds, which do well when rates go down, and about half in fixed to floating or variable coupon bonds which provide protection should rates go up. The strategy’s empirical sensitivity or beta to interest-rate moves (taking the 10-year swap rate) over the last three years on both a rolling 260 days and 120 days shows the strategy to be quite interest rate indifferent within the bands of the moves in the last three years. If rates look as if they are going to move much wider than 1% in 2018, which is not our expectation, we would of course review our positioning.
 
Politics
While the precarious political majorities in many countries and Brexit in the UK will provide an enormous source for journalistic comment and TV or radio airtime, political changes over the past few years have tended to express themselves mainly in the currency markets where we are hedged and/or in equity markets rather than impacting on the credit quality of investment-grade companies.
So while we always keep a ‘weather eye’ on political developments, we will spare you from prognostications which should not have too much impact on our holdings.
 
The one politically influenced theme we do follow closely is financial regulation. Financial regulators are still on a mission to increase the safety of the financial system and avoid systemic turmoil, which brings us to our next point.
 
Favoured sectors
Within Europe, the financial sector remains the ‘sweet spot’. The continuing imperatives of the 10-year implementation of Basel III that started in 2012 and its extension just announced in December, nicknamed Basel IV, is a transformation that is very supportive of the subordinated debt of ‘national champions’ in which we like investing and which will remain our focus.
 
With a supportive macro background, and a favourable sector to invest in, we must still remain vigilant on a country by country and a name by name basis. Our focus remains on investing with strong companies in strong countries with our aim to collect coupons and provide a yield which can be seen as not only attractive in nominal and real terms but also compared with other income-earning classes.
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