Risk Assets Enter a Short-Term Holding Pattern

Between the uncertainty driven by the change in the administration and the arrival of fourth-quarter earnings season, risk assets entered into a short-term holding pattern last week. The average corporate credit spread of the Morningstar Corporate Bond Index, our proxy for the investment-grade bond market, was unchanged at +127 last week. In the high-yield market, the credit spread of the Bank of America Merrill Lynch High Yield Master Index was also unchanged at +402. In the equity markets, the S&P 500 was essentially unchanged for the week, declining 0.10%. Price action in the commodity markets was mixed, but overall price changes were modest.

A significant portion of investors’ caution toward the corporate bond market is the acknowledgment that corporate credit spreads are trading at very tight levels compared with recent and historical averages. The current level is the tightest that credit spreads have registered since late 2014 and significantly tighter than long-term averages. The average spread of the Morningstar Corporate Bond Index is 41 basis points tighter than the long-term average of +168 since the end of 1998. The average spread of the Bank of America Merrill Lynch High Yield Master Index is currently 178 basis points tighter than its long-term average of +580 basis points since the end of 1996.

Fourth-quarter earnings releases began last week with the global banking sector reporting first, and the pace in other sectors will ramp up this week. While fourth-quarter results will help investors gauge near-term corporate credit risk, the real focus will be on 2017 guidance and any potential changes in capital-allocation policies. In addition to the volatility that earnings can generate, with the change in the administration, many investors are treading cautiously in the market until there is greater clarity regarding the policies that President Donald Trump will pursue in the near term. As such, defensive issuers generally traded better last week, although there did not appear to be a significant sector rotation toward a defensive portfolio posture.

After declining the prior week, interest rates bounced slightly higher in the United States and are nearly unchanged year to date. However, interest rates in Europe continue to rise toward their highest levels of the past year as inflation in the eurozone is showing signs of accelerating. Eurostat reported that annual inflation in the euro area accelerated 1.1% in December 2016. That compares with 0.6% in November and 0.2% in the year-ago period. The inflation rate in Germany (the single largest economy in Europe) rose 1.7%. The yield on 10-year German bonds rose to 0.42%, the highest since January 2016. Comparatively, inflation in the U.S., as measured by the Consumer Price Index, rose 2.1% for the 12 months ended December 2016. In his first-quarter 2017 outlook, Robert Johnson, Morningstar’s director of economic analysis, forecast that inflation will continue to accelerate over the course of the year. Currently, he projects that the U.S. core inflation rate will rise to 2.4%-2.6% by the end of this year.

After reaping double-digit returns last year and with greater short-term uncertainty building, investors decided to reduced their exposure to the high-yield asset class last week. For the first time in over two months, high-yield exchange-traded funds suffered from an outflow as over $1.0 billion in assets were redeemed out of the asset class.

Morningstar Credit Ratings, LLC is a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization (“NRSRO”). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at https://ratingagency.morningstar.com