The dramatic fall in commodity prices has been a major theme in financial markets recently. Amid an excess in global supply and signs of slowing demand in China, the world’s biggest importer of commodities, no recovery is yet in sight. The deteriorating market sentiment and increasingly broad risk aversion has led to underperformance among the riskier fixed income categories, specifically high yield, where we closed our overweight on US paper and reduced the overweight for Europe.
EM, HY and commodities since May 2015
Sentiment for commodities remains in deep slump
China’s devaluation of the yuan last month did little to boost sentiment for commodities, which was already clearly negative. By reducing the value of its currency, China in effect raised local-currency import prices, a move that would normally damp demand. Given the limited extent of the depreciation, at least so far, and the drop in dollar-denominated commodity prices that followed the news, the actual impact may be less profound.
The combination of higher local Chinese prices and lower international prices opens up opportunities for arbitrage trade, which may support Chinese commodity imports in the near term. The world’s leading commodity importer, China functions as an international bellwether for the strength of demand for commodities. Any levelling off in the nation’s commodity import demand could trigger another leg down for commodity prices and sentiment.
China may not maintain oil demand levels in H2
China’s commodity imports held up well in the first half of 2015 and continued to do so in July. Oil imports in particular have remained strong. In response to low prices, the country has boosted purchases of crude oil to build up its strategic reserves. China is replenishing its stockpiles of oil products as well, and is increasingly becoming a net exporter of refined oil products, further underpinning its demand for crude oil imports. Whether China’s demand for oil will hold up in the second half may depend on the slowdown in the nation’s economic growth. That slowdown appears to be accelerating.
In any case, the yuan devaluation fits well with China’s well-established commodity strategy of importing raw materials, refining locally and exporting to world markets any surplus of refined or semi-refined products – those made with steel, aluminium or oil, for example. A depreciating currency supports this strategy.
Oil recovery may depend on stress among US HY producers
Not surprisingly, commodity segments most exposed to China posted the biggest declines in August. Examples are energy and industrial metals, both of which underperformed last month and so far this year. The tempestuous trends in commodity prices and on China’s equity markets are also making waves on fixed-income markets. At the centre of the storm is US high-yield paper, where the sensitivity to oil and industrial metals is highest.
As the strength of China’s demand for oil becomes increasingly questionable, the decline in oil prices has meanwhile accelerated. A reduced US oil production forecast from the Energy Information Administration help stage a late-August rally in the price of West Texas Intermediate as well as London-traded Brent, but upside in oil prices seems limited. With an unresolved global excess oil supply and pending refinery maintenance weighing on the demand side, oil prices may not reach their bottom until there is tangible evidence of stress at shale producers in the US, many of which are financed with high-yield debt.
Defaults in US high yield may therefore lie ahead. Investor flows and momentum also remain negative. In view of the renewed Chinese equity market stress, we closed our overweight in US high yield and reduced the overweight in Euro high yield from medium to small.
Triggers for sentiment reversal seem unlikely
Sentiment for US high yield is unlikely to improve much in the near term. Key factors needed for a reversal seem unlikely at this point. One important trigger for a reversal would be a bottoming of commodity prices and oil prices in particular. The risk of a further decline in oil prices is significant as this appears the only channel to scale back US shale oil production. Demand weakness and lack of production discipline indicate that a sustainable rally in commodities is unlikely at this point.
Some form of stabilization in Chinese macroeconomic data and equity markets may also be needed to entice investors into the riskier debt markets. The recent focus on the Chinese authorities’ credibility make this also unlikely in the near term. Investors and non-investors locally and abroad seem to have lost faith in Chinese policy makers’ ability to turn the tide.
European HY faces increased contagion risk
In the current environment it is difficult to imagine that the European high yield debt category would be completely sheltered from the severe headwinds facing its US counterpart. Investment flows are probably even more important for European than for US high yield paper. Whereas US high yield has witnessed outflows this year and last, European high yield attracted +16% of assets under management in inflows so far in 2015, after inflows of +10% in 2014.
Sentiment reversals and subsequent investor outflows are of course potential headwinds for high yield paper in the US as well as Europe. But given market capitalization and historic inflows, they probably pose a bigger threat to European high yield. At a time with low market liquidity in spread products, investor flows can carry a big impact. And while European paper has outperformed US in the high yield category, contagion risk has recently increased. Nevertheless, European earnings and macroeconomic resilience, as well as the region’s lower government bond yields, still favour a small overweight to the category.
In emerging market debt (EMD) categories we remain underweight. The underweight in EMD hard-currency (HC) corporates was further increased to medium from small. We expect recent pressure on the class to continue as troubled EM countries are heavily represented in the index (China 20%, Brazil 15%, Russia 9%, Turkey 3%).
While the recent sell-off in credits has undoubtedly improved valuations, particular in USD paper and EMD, we see fundamental reasons for the sell-off. These fundamentals need to improve for investors to be tempted again by the increasingly attractive yields on offer in HY and EMD HC.