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December 2018 | GSAM Connect

2019 Outlook: Continue to Tread with Caution and Conviction

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Overview

Following a sharp reset lower in valuations in 2018, particularly during this quarter, we think the early-2019 investment backdrop presents an opening to add exposure to high conviction views at attractive levels. We are overweight US investment grade and US high yield corporate credit, and in dedicated portfolios we are overweight European high yield. At this stage of the cycle, we think it makes sense to continue to ‘tread with caution but conviction’ as our 2018 Credit Outlook was titled. In our view, this entails overweight exposure to corporates with strong or improving balance sheets. We are also alert to opportunities in issuers with high interest coverage ratios and pricing power as we enter an environment of higher input and wage costs, while we are underweight issuers that face secular or cyclical challenges, or both

  • US corporate credit: Heading into 2019, we are overweight US corporate credit; both investment grade and high yield. This contrasts with our stance at the same juncture in 2018 when we were neutral to modestly overweight. Conditions are not too dissimilar to those outlined in last year’s Outlook; the growth backdrop is still expansionary, companies are still profitable, median leverage ratios remain in check, and although share buybacks have picked-up, they have been largely concentrated in the Technology sector. That said, corporates are beginning to pivot expenditures toward shareholder friendly activities such as share buybacks and dividend payments relative to capital spending; we will be closely monitoring these traits as the cycle progresses. Nonetheless, there is one crucial difference relative to last year; valuations. Heading into 2019, spreads are not at historical tights as they were when we entered this year (see Figure 1) and certain credits appear undervalued relative to underlying fundamentals. Taken together, these two factors – less stretched valuations and still-healthy fundamentals – lead us to be overweight US corporate credit.
  • European corporate credit: In global portfolios, we have a preference for US over European credit, due to lingering political tail risks in the latter alongside reduced central bank support and a more modest growth backdrop. In dedicated European credit portfolios, we are modestly overweight European high yield. The rationale is similar to our US exposure outlined above; we think recent de-valuations have surpassed what is implied by underlying fundamentals. The sector is pricing a 6.9% default rate; far exceeding the current 1.1% default rate and closer to the 10% default rate priced during the global financial crisis. Spreads have widened considerably relative to this time last year (see Figure 1). We think these moves are excessive and open the valuation door to add idiosyncratic exposure to issuers with robust fundamentals. That said, in the near-term we continue to expect headlines around (geo)politics and waning macro momentum to steer spread moves. Catalysts that would lead us to be more constructive on the sector include productive Brexit and Italian budget negotiations, easing trade tensions and a pause or reversal in the deceleration of Euro area macro data.

Figure 1: Unlike last year, valuations are attractive heading into 2019 for still-healthy fundamentals

Fixed Income Risk Premiums vs History

    Source: Bloomberg, GSAM, as of November 2018.

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