The leveraged loan market’s growth has created some investor concern. Much of the growth has been driven by collateralized loan obligation demand. These buyers are more concerned about the loan characteristics fitting their model than about the credit and covenants. As a result, “covenant-lite” deals have grown substantially, which typically reduces default risk but also reduces recovery values. This loan growth has resulted in “first lien” obligations becoming a greater proportion of corporate capital structures – also potentially reducing the recovery value of high yield bonds. These concerns will be more valid when the credit cycle turns. But fundamentals suggest the cycle is still going strong, with interest coverage ratios high and default rates falling. Further, the loans market has grown into a separate asset class. An increasing number of loan issuers only issue in that funding market – not the high yield market as well. Per the chart, 59 percent of the leveraged loan market is completely separate from the high yield market. The loan market’s effect on high yield deserves consideration, but should be kept in perspective.
Equities
In the context of a more neutral risk appetite, we have further reduced our exposure to global equities. We now sit with a neutral allocation across the developed equity markets and a 3 percent underweight to emerging market equities. In the U.S., we are incrementally concerned that the market has not fully contemplated the potential tariff impact on those segments dominating returns year-to-date, including technology. In addition, pressure on (record) profit margins manifesting from higher input costs (commodities, logistics, labor and – more recently – interest rates) will limit the ability of earnings growth to materially outpace slowing revenue growth in 2019. Notably, valuations have improved this year as U.S. stocks have failed to keep pace with strong 2018 earnings growth, helping to provide downside support.
Meanwhile, we remain cautious on the tactical outlook for emerging markets. A seemingly resolute Fed – intent on further increasing rates – combined with the potential for growth in China slowing further as tensions with the United States persist, suggest a more guarded positioning. U.S. investors also are concerned with the Fed’s optimistic outlook, which has pushed rates – and stock market volatility – higher.
Real Assets
The fortunes of global real estate (GRE) and global listed infrastructure (GLI) relative to global equities are largely tied to the interest rate environment. GRE and GLI materially lagged the global equity markets this year through the month of May as interest rates moved higher. After a brief respite, during which interest rates stopped going up and both GRE and GLI pulled closer to even with global equities on the year, the relative performance pressures re-emerged. Recently, GRE and GLI have been better behaved – somewhat surprising given the recent spike in interest rates. This very recent outperformance may indicate two dynamics at play: GLI/GRE sentiment has finally bottomed out after a prolonged period of underperformance and investors outside the fixed income markets may be attributing the recent spike in rates to technical – or other temporary – factors.
We remain strategically allocated to global real estate and listed infrastructure for their diversification properties, but believe it will take some time for rates to settle into their new channel and, therefore, are not looking overweight these asset classes at this time. Meanwhile, we also remain tactically neutral natural resources. Expectations for slowing global economic demand should – all else equal – cap commodity price appreciation; but continued geopolitical dynamics – including the recent tensions between the United States and Saudi Arabia – support our strategic allocation.
