The markets may seem to have quietened a little after a rocky start to the year, but there are still a number of potential nightmare scenarios out there that keep big investors up at night.
Goldman Sachs Asset Management’s credit team set out its biggest worries in its monthly fixed income round-up.
Bond spreads have widened over the past few months, driven by fears over China and a possible US recession. The question is whether markets have overreacted, or whether they are a harbinger of things to come.
“We face an environment of uncertainty which requires a cautious approach,” the GSAM round-up said.
“It is not clear whether corporate credit is the canary-in-the-coalmine that will lead capital markets down, or a phoenix that can offer a dramatic rally from current levels,” it added.
The credit team at GSAM set out their biggest concerns, and what they think the market is worried about. As you can see, GSAM is more concerned about lending conditions than most, and less worried about liquidity in the bond market.
Here’s a quick rundown of each Goldman credit concern:
- Commodity Prices: This is largely due to the level of high yield debt issued by energy producers. “If prices remain depressed, we would expect to see as much as 20% of the high yield energy sector default in 2016, a further 15% in 2017, and a cumulative three-year default experience (including 2015) of fully 50% of the sector,” said the note. In turn this may “pose some indigestion challenges in the face of declining demand for lower-rated credit.”
- Global Growth: Slowdowns across the globe are weighing on the Goldman teams’ minds, especially in China. “The signals from China to commodity-exporting emerging markets are worrisome in our view; combined with rapid debt growth in recent years and an increasingly strong dollar, the economic headwinds for the likes of Brazil and Russia remain daunting,” said the note. A slowdown in growth, by extension, could freeze up the credit markets.
- Lending Conditions: As we’ve pointed out before, the lending practices of some financial institutions are beginning to signal a shift in the credit cycle.”We believe the recent tightening of lending conditions is not broadly recognised by the market: this shift helps to explain the current wider spread environment, and would likely need to improve to justify any persistent move tighter,” said the note.
- Central Bank Policies: Negative interest rate policies from central banks around the world and the impact on credit markets have also caught Goldman’s eye. “As rates remain negative or potentially get more negative, there is the potential for more investors to move into investment grade debt in search of positive yields,” said the note. “However, this trend of reaching for yield could be tempered if monetary policy and further negative rates become perceived as increasingly ineffective or even counter-productive.”
- Liquidity: While liquidity in credit markets has garnered a lot of attention, Goldman said investors shouldn’t worry. “Ironically, the topic which has been high on investors’ worry list is a relative bright spot among these key indicators,” said the note. “Credit markets have experienced some tightening of liquidity conditions but relatively minimal compared to other asset classes where investors are less prepared to take risks.”