Get ready, investors.
In the months ahead, the US high yield bond market must contend with a less accommodative Federal Reserve, geopolitical tensions, the impact of US tax reform, and regulatory rollback on a range of issuers. While the US economy remains strong, investors will need to navigate tariff-inspired volatility with particular care.
Following the imposition of import taxes on washing machines and solar panels in January, as well as steel and aluminum tariffs in March, the Trump administration called for 25% ad valorem duties on $50 billion worth of US imports from China in early April. China countered with proposed tariffs of a similar magnitude on US products (autos, agriculture, aerospace, etc.), before Trump further escalated tensions by threatening to expand the scope of impacted goods by an additional $100 billion.
The Administration hopes that tariffs will reduce the US trade deficit with China and spur domestic economic growth, but retaliation that spirals into a trade war could counteract this effort, boosting inflation and rates without positive GDP implications. Additionally, heightened uncertainty may degrade sentiment, particularly in manufacturing (the most recent ISM Manufacturing PMI survey remains elevated but showed signs of deceleration in March, with several respondents citing supply chain disruptions and panic buying of metals as a result of tariff fears).
It's important to remember though that presently contemplated tariffs amount to less than 0.3% of US and China GDP, a relatively inconsequential figure even in the absence of compromise or trade substitution.
Neither side seems to have a strong incentive to incite a trade war. US exports to China total $130 billion per annum, while imports exceed $500 billion, resulting in a substantial trade surplus for China that theoretically caps its retaliatory power. The Trump administration, for its part, can ill afford economic turmoil ahead of expectedly contentious mid-term elections that could reverse control of Congress. Furthermore, Trump could soften his stance on trade in exchange for China's help in achieving denuclearization of North Korea, a policy priority for the Administration.
In the short term, proposed tariffs that benefit primary steel and aluminum producers are likely to come at the expense of downstream metal consumers, whose input costs could rise. Recently announced duties tied to intellectual property issues if enacted, may disrupt the supply chains of US-based integrated tech manufacturers and makers of machinery. Domestically focused US industries - such as hospitals, oil refiners, equipment rental companies - that trade off in sympathy with the market on general trade war fears may offer attractive value given end-market insulation.
Ultimately, the modest size of proposed measures relative to nearly $650bn in annual trade between the US and China must not be overlooked. In his April 10 speech at the Boao Forum, Chinese President Xi Jinping hinted at a more open Chinese economy, including a reduction in auto tariffs and greater enforcement of intellectual property - seemingly addressing a key factor in the Office of the US Trade Representative's Section 301 investigation, further supporting our view that inflammatory rhetoric will subside and pave the way to compromise.
High yield investors have cause for optimism despite the risks. Strong credit fundamentals, a supportive technical backdrop and positive macroeconomic indicators underpin the market. With little recession risk over the next twelve months, we believe yields are compelling relative to other asset classes. Disruptions that arise from fears of a trade war that both the US and China appear incentivized to avoid may provide an attractive entry point for investors seeking exposure to US high yield.
About the Author
Michael Salice is Director of Research at SKY Harbor Capital Management, a Greenwich, CT-based leveraged credit asset management firm that specializes in broad and short duration high yield strategies and serves as investment manager for SKY Harbor Global Funds high yield UCITS funds. Mr. Salice oversees standards across the research team and maximizes the overall value of fundamental research through synthesizing trends and coordinating thematic research projects. Mr. Salice is also responsible for coverage and credit valuation for the Basic Industry sector and Environmental and Railroad industries. He was previously in the high yield research group at GE Asset Management covering the chemicals, healthcare and paper & forest products sectors.
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