What a difference a year makes. One year ago, financial markets were full of worry. Equities were down by double-digits, oil was tanking, and high-yield credit spreads widened to over 800 basis points.
In contrast, equity markets today are at record highs, oil has recovered more than 40% from its low, and high-yield credit spreads have tightened to below 400 basis points. This leads us to ask ourselves, if markets were too pessimistic last year, are they too complacent today?
Over the near term, our research and process suggest we have reasons to remain positive. As we wrote last month in our 2017 Outlook, the economic environment is supportive of risk assets, with most developed economies in expansion territory and many emerging markets in recovery.
The risk environment is also supportive, as volatility remains low across most assets, especially in equities, where measures of both realized and implied volatility are among the lowest we have seen since mid-2014.
So far, so good.
However, improvements in the economic and risk environments have also driven valuations higher, to the point where there are few bargains remaining. And if we extend our time horizon beyond the next couple of quarters, we see a source of potential weakness in the form of an aging credit cycle.
Warning Signs Ahead for the Credit Cycle
We recently published a white paper, “Investing Through the Credit Cycle,” that discusses the evolution of the credit cycle and how it impacts asset performance. Today, we are beginning to see warning signs that the cycle’s end may be approaching. Corporate leverage has been rising, and likely will continue to do so. While that alone is not enough to signal the end of the cycle, if the Fed tightens further this year, leading to tighter credit standards and slowing growth, we believe markets would be vulnerable. This is particularly true in high-yield corporate bonds, which have been among the best performing assets over the last year, and are expensive today by historical standards.
How We’re Positioning Portfolios
Given this view, we have further reduced our exposure to high-yield corporate debt and are maintaining positions in loans and emerging market debt, where we see more attractive valuations. Beyond that, we maintain similar positioning to last month for a global 60/40 portfolio:
- Overweight equities;
- Underweight interest rate duration;
- Modestly long the U.S. dollar, overweight a basket of higher-yielding emerging currencies and underweight lower-yielding developed currencies.
Despite trimming our high-yield exposure, our portfolio positioning remains consistent with our positive near-term outlook for risk assets. We continue to closely monitor our credit cycle indicator and its inputs, notably corporate leverage, interest rates and lending standards, for signs of weakness in the credit cycle, and will adjust our positioning as needed.
Visit our Global Multi-Asset Group webpage for additional insights about asset allocation and multi-asset investing.
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Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall.
The S&P 500 Index is a free-float, capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the United States.
The MSCI AC World ex-U.S. Index is designed to measure the equity market performance of developed and emerging markets and excludes the U.S.
The MSCI AC World Index is a free float-adjusted, market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets.
The MSCI Emerging Markets Index is designed to measure the equity market performance of emerging markets.
The Bank of America Merrill Lynch U.S. Treasury Current 10 Year Index is a one-security index in which the current “on-the-run” issue for the 10 Year maturity remains in the index until the date a new one is auctioned and settles.
The Bloomberg Barclays Global Aggregate Index provides a broad-based measure of global investment grade fixed-rate debt markets. The index is comprised of several other Barclays indexes that measure fixed income performance of regions around the world
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These views represent the opinions of the portfolio manager at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.