As political debates play out in the second half, Invesco Fixed Income expects credit markets to remain well-supported by foreign demand as global central bank policies have produced meaningful interest rate differentials, despite growing hedging costs. In addition, debt issuance will likely be contained, in our view, as debt-funded merger activity is anticipated to decline with the return of global growth impulses. Our active research process leads us to varying views on key sectors, which we will highlight in this outlook.
Tax reform remains a key issue
Investors had high expectations for policy changes immediately after the election, but have since been disappointed with the follow-through. Health care has been a perfect example, as policy proposals marketed as a quick “repeal and replace” have turned into a lengthy debate, potentially resulting in another compromise that will only place another bandage on an ailing system. In addition, tax reform will likely not get any easier, as the new Congress has initially proven to be a headwind to change.
We continue to think that some version of tax reform will eventually get passed, potentially in the form of reduced corporate taxes and/or a tax holiday for repatriated income that would likely be positive for US companies. We also believe that progress toward establishing a less stringent regulatory environment could aid future economic growth.
Global growth remains supportive of corporate credit
There were some bright spots in the first half of the year, as the US economy and employment continued to show steady growth. Both of these trends were supportive of credit fundamentals and investor sentiment, and spreads ground tighter across all credit sectors.
First-quarter earnings for the S&P 500 Index companies were up over 14%, with revenue growth of 7.8% (just under 4% excluding energy and finance), according to Bloomberg L.P. At Invesco Fixed Income, we expect second-quarter 2017 earnings growth of around 9% year over year and revenue growth of around 5%. While this forecast represents a decline in sequential growth expectations, it remains above fourth-quarter 2016 growth rates.
As active managers, we are focused on rigorous fundamental research, and our bottom-up analysis drives our portfolio positioning and security selection. Here are some of our forward views on key sectors:
Bottom line: We continue to prefer cash-generative, midstream assets (such as pipelines, shipping companies and storage facilities) with less direct commodity exposure. We also prefer higher quality exploration and production companies with the flexibility to sustain periods of weak commodity prices.
The global oil supply/demand imbalance remains pressured, with the positive impact of OPEC production reductions being partially offset by increasing US drilling activity. Any further production cuts could result in market share losses to other worldwide producers, while potentially benefiting US shale producers, whose break-even costs have fallen dramatically due to both continued technological innovation and falling expenses for oil field services. However, we think the Kingdom of Saudi Arabia will attempt to defend the oil price level in advance of an expected 2018 initial public offering of Saudi Aramco. Thus, prices in the medium term may remain volatile and range-bound.
Bottom line: We remain cautious on the sector, particularly on apparel retailers, while favoring companies that are internet-resistant, including discount stores and companies with well-defined e-commerce strategies.
US consumers continue to reduce discretionary spending while increasing spending on nondiscretionary expenses, like health care and housing. Within discretionary spending, consumers appear to prefer experiences over goods. As a result, the traditional retail sector has struggled against a relentless onslaught from online competition. We expect this ongoing secular change to have a meaningful impact on traditional retailers for some time. The number of store closures and bankruptcies will likely continue to mount this year, in our view, with many stores and companies probably headed toward liquidation. This will likely have a negative impact on both retail operators and retail real estate owners facing lower retail square footage demand across the US.
Bottom line: We expect volatility in health care credit to remain high. However, most sub-sectors within health care remain investable, in our view, and we believe volatility should be viewed as a buying opportunity.
The area with the most risk continues to be highly leveraged acute care hospitals that are more exposed to cuts in Medicaid coverage. Also at risk are less innovative specialty pharmaceutical companies that are losing revenues (due to generic competition and pricing pressure) faster than they can be replaced by development pipelines. Changes in health care policy remain uncertain, and the proposals seem to change depending on the day. What we do know is that Republicans are having a much more difficult time agreeing on what should be changed under the Affordable Care Act than many observers expected. The debate is complicated by the fact that health care is expensive, particularly for an aging population.
Telecommunications, media and technology (TMT)
Bottom line: While “cord-cutting” (canceling cable television subscriptions or landline telephone connections in favor of alternative internet-based or wireless service) continues to be a risk, we like the sector for its stable earnings profile, driven by growth in broadband.
We expect mergers and acquisitions (M&A) to continue to drive the TMT sector as Washington promotes a more favorable regulatory environment. In the wireless segment, M&A risks have risen and will likely remain high, driven by strategic positioning in preparation for fifth-generation wireless and mobile systems. The cable sector is also likely to continue to see M&A, driven by strategic interest in content and the consolidation of technologies that enable services.
Bottom line: Spread premiums available in subordinate securities are currently very tight after a lack of supply in the first half of 2017, but we expect issuance to pick up in this space in the second half of the year.
We expect continued easing of regulations even without a full repeal of the Dodd-Frank Act and its rules for the financial industry, and we note that much can be done by political appointees without approval from Congress. Banks have built strong capital and liquidity positions over the past few years, as evidenced by the recent Federal Reserve (Fed) stress tests (called the Comprehensive Capital Analysis and Review tests) and subsequent regulatory approval of shareholder distributions. A higher and/or steeper yield curve coupled with improving growth bodes well for continued strength in the sector, in our view.
Positive on US credit overall
We remain positive overall on US credit fundamentals, driven by supportive economic growth in the US and globally. The healthy US labor market should continue to provide the foundation for ongoing recovery in consumer confidence and, ultimately, spending. We expect global demand for credit assets to remain strong and believe new issue supply is likely to be contained.
Our optimism is tempered, however, by valuations that, in most markets, are approaching historically tight levels. Our largest concern centers on the potential for a Fed policy error that could tighten financial conditions in the face of still-modest economic growth. In addition, limited progress on US health care and tax legislation could dampen investor confidence and result in higher risk premiums.
The Bloomberg Barclays U.S. Aggregate Index is an unmanaged index considered representative of the US investment grade, fixed-rate bond market. An investment cannot be made into an index.
The Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Cap Index is an unmanaged index considered representative of the US high yield, fixed-rate corporate bond market. Index weights for each issuer are capped at 2%.
The Bloomberg Barclays U.S. Corporate Index is an unmanaged index considered representative of publicly issued, fixed-rate, nonconvertible, investment grade debt securities.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply and demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.
Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.
Commodities, currencies and futures generally are volatile and are not suitable for all investors.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The PowerShares Bank Loan Portfolio ETF (NYSE:BKLN) was unchanged in premarket trading Friday. Year-to-date, BKLN has gained 0.31%, versus a 9.76% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.