2014 US Credit Outlook - Living in a Lean World

2014 US Credit Outlook - Living in a Lean World

Mark Howard, Colleen Watson, Ashish Jain - Credit
The Weekly Credit Pulse | 12 Dec 2013 16:47 | 1131 Kb

Summary
2014 US Credit Market Roadmap
US credit spreads are likely to grind tighter through much of 2014, but the path will not be linear or easy. Decent fundamentals and solid inflows are offset by rising interest rates, suppressed volatility, and skinny valuations. Total returns are expected to be modest in 2014 given our rates forecast, but excess returns are expected to be decidedly positive. We forecast 13bp of cash IG spread tightening and 58bp of HY tightening by year-end.

Macro Drivers
Credit fundamentals are expected to be supported by modestly improving global economic growth. As tapering will not be a surprise and market participants have adjusted duration postures, we expect credit spreads to compress somewhat in reaction to higher rates.

Credit Foundations
Demand for dollar spread product should remain broad-based reflecting central bank, demographic, regulatory and new product drivers. Fundamental credit trends in the US are unlikely to change sufficiently to influence valuations next year. Both macro and idiosyncratic volatility are likely to remain muted through much of the year, so pockets of elevated volatility can be exploited to boost returns.

Portfolio Positioning
We prefer US high yield to investment grade, with single Bs offering the most attractive risk-adjusted return prospects. Within IG, we expect triple Bs to best single-As, industrials to slightly outperform financials and European Yankees to benefit from the cross-currency basis. We prefer the 5-10yr part of the cash curve and 3s5s in CDS. At the sector level, we are cautious about event risk in high beta sectors (Retail, Metals & Mining, Media and Telecom) and view Utilities, Energy, and Technology as core holdings. Synthetic credit may modestly lag cash markets, having dramatically outperformed in 2013. We have a constructive view on negative basis packages, due primarily to carry, not expected spread compression. The US synthetic credit indices are also expected to underperform versus high beta equities.

Key Risks
While major volatility spikes seem unlikely, several macro surprises and credit-specific factors could emerge that would temporarily weigh on sentiment. An escalation of global deflationary concerns, due to a growth slowdown or signs that quantitative easing were failing to support the markets, would likely result in a repricing of risky assets. Likewise, an unexpected spike in UST yields would be expected to temporarily hurt credit excess returns due to fund outflows. An exogenous shock could temporarily impact liquidity and volatility. An acceleration of activist shareholder initiatives and/or a resurgence of private equity investment in corporate America is not currently priced into IG industrial valuations. Any of the above-mentioned developments may compound the impacts from new bank capital and liquidity regulations to cause temporarily magnified price moves.

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