US Credit Update – Tariff Impact on Materials, Industrial Sectors
Highlights from the U.S. credit markets:
- Another challenging week for credit
- New issuance underperforming
- ETF outflows have eased
- Tariffs put materials, industrials in focus
- Setback for software
- Banks still under pressure
Another challenging week for credit
U.S. investment grade and high yield underperformed last week. The one-two punch of Trump administration tariffs and Bank of Japan beginning to discuss timing for an unwind of QE put risk markets on their heels. Spreads widened across the board as Treasury yields moved lower. While this round of tariffs alone is expected to be insignificant for the board economy, there will be industry-specific impacts. Risk market jitters appear more tied to concerns for push-back and even retaliatory policies from allies. Our corporate desk had the following summary on Friday:
The financial sector was one of the hardest hit this week. Domestic names receded 8-13 basis points with BAC and WFC being the worst performers. Over the past month, the sector is +23-32 basis points. The weakness in high yield and higher beta names could be attributed to Trump’s plan to place tariffs on the steel industry. Domestic steel producers NUE, X, and AKS should perform well, but their foreign counterparts in China, Canada, Mexico and Asia could struggle if modifications are not made.
The Bloomberg Barclays U.S. corporate total return index fell 0.2% last week, extending losses as safer assets continue to find firmer ground. Leveraged loans (+0.1%) remain resilient along with mortgage-backed securities.
New issuance underperforming
Primary market activity picked up last week but the reception was a bit chilly. Bank of America brought the largest deal ($7 billion) and financials accounted for roughly half of issuance. Energy, utilities and consumer sectors all saw a handful of decent-size deals. Our corporate desk noted many of these leaked wider.
It was a rough week for credit as it underperformed other risk markets. The IG index widened +4 basis points while HY fell $1 point. The cash markets showed worse results and more importantly, bid-ask spreads widened and new issuance performed poorly. Expect a wider new issue concession for coming deals.
February saw $130 billion of new IG/XO paper priced, which brought our 2018 total to $289 billion for the first two months. This is -14% YTD. Much of this week’s issuance widened by week’s end and there was a very limited backstop for the flippers. The largest domestic deal of the week was a $7 billion, 3 tranche transaction by BAC. While the deal came with some concession to existing paper, it still went out 7 basis points wider. Outstanding BAC 10-year paper backed up +13 basis points this week. Among non-financial issuers, SBUX 10-year, which was priced Monday at +67, closed the week +15 basis points. There continues to be good demand for subordinated fixed-to-float paper, as ENBCN and HBAN both saw their deals well received. And a 5-year from KEY, which priced at +73, tightened a basis point to +72/70.
ETF outflows have eased
The wave of net-outflows that broadsided U.S. corporate bond ETFs appears to have subsided. The chart below shows the 20-day sum of net flows for U.S. corporate bond ETFs peaked in mid-February and have receded as flows became balanced late in the month. But while outflows have eased, we have not seen any rush by buyers. The reduced appetite for U.S. corporate exposure via ETF is persistent. We noted the heavy short positioning in U.S. credit ETFs, especially among high yield funds last week in Newsclips. Discussions with fund managers suggest institional participation in credit-backed ETFs is higher than for other types of funds, and these ETFs are often used as cash management tools. To the extent that is true, some of the net outflows from corporate ETFs may have been managers putting the proceeds to work in the cash market. This would have no bearish implications for the asset class, despite appearing as an outflow here. We wonder if some of the shorts have misread the outflows.
Tariffs put materials, industrials in focus
The first major tariffs since George W. Bush introduced steel tariffs in March 2002 reverberated through risk markets late in the week. Tariffs of 25% of imported steel and 10% on imported aluminum seemed to carry more weight in signaling than direct impact. Most of the hand-wringing was about retaliation and what these moves meant for additional measures down the road. Industrial names were actually among the better performers on the week on a spread basis.
The chart below shows the average 1-week change in spread to benchmark Treasury, by sector, for issues over $750 million in size in the Bloomberg Barclays U.S. industrial total return index. The x-axis is the duration in 2-year intervals. Materials (blue marks) performed well but industrials (yellow marks) actually saw better spread performance than most other sectors across the curve.
Here we take a closer look at the mining sector and on the top consumers of steel and aluminum, aerospace and defense. The charts below show changes in spread to benchmark treasury for the week. On the left are aluminum, copper and iron miners. Both iron and aluminum miners outperformed copper, which is sure to light a fire under a lobbyist somewhere. Spreads for aerospace and defense issuers underperformed on the week. Many of these firms are exposed to higher materials costs but also face diplomatic headwinds with customers miffed by national security tariffs.
The recoil from tariff news sent industrials sharply lower, further eroding total return performance for 2018. The charts below show average total returns (left) and average total returns by average duration (right) for sectors within the Bloomberg Barclays U.S. industrials index. We limit the universe to issues with $750 million or more in par value. Industrials are now the worst performing sector, on average, with total return losses of -3.5%. Energy remains the most resilient, especially when compared to duration peers.
Setback for software
Technology has been one of the safe havens for investment grade investors. We’ve highlighted how the largest names in tech were more resilient during February’s turbulence. The story changed last week as the largest computer and software names underperformed. We also saw spreads for longer durations underperform, reversing a trend we’ve noticed in recent weeks where investors seemed more interested in longer paper.
The charts below show 1-week changes for select industries within the technology sector of the industrials index. Among computers, both Apple and IBM saw spreads underperform and longer-dated paper saw spreads widen by roughly 10 bps. Among software issuers, Microsoft and Oracle also saw spreads 5-10 bps higher for mid-duration issuers. Microsoft saw longer-dated paper underperform as well, widening 10-15 bps. This paper had been in demand so a back-up in spreads may find willing buyers. We’ll be very curious to see if these issues are among to first to recover if the risk market jitters pass.
Banks still under pressure
Bank performance persisted last week among the broader move wider in spreads. The chart below shows the average weekly change in spread to benchmark treasury by duration bin. Banks (dark blue) underperformed other industry groups within the Bloomberg Barclays U.S. financials index at all but the shortest duration. Here we include only issues with at least $500 million in par value outstanding. Bank spreads were wider on average by 8 bps or more for issues with durations over 6-years. Once again, longer-dated spreads underperformed, defying a trend we’d talked about in Newsclips last week.
On the year, banks (-2.0%) are still in the middle of the pack among their financial sector peers. Insurance and healthcare-services continue to underperform, weighed down by longer average durations. Smaller industry groups with shorter average durations, both savings & loans and investment companies continue to outperform.