Credit market ignoring the trade war, how UBS says to prepare for rude awakening

Reuters / China Daily CDIC

• As President Donald Trump’s mounting trade war has
  thrown everything from stocks to commodities for a loop, the
  credit market has soldiered on, largely unperturbed.
• UBS says it’s in for a rude awakening, outlines two
  possible scenarios, and offers a handful of trade
  recommendations for investors who want to protect themselves
  from the fallout.

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There’s no denying that President Donald Trump‘s ever-escalating
trade war has rattled investor
nerves. Its shockwaves have been felt throughout large
swaths of the market.

But amid all the fervor, one asset class has remained largely
nonplussed: credit.

“Unlike growth-sensitive assets like global stocks and
commodities, developed market credit has thus far failed to raise
any flags on trade tensions,” Bhanu Baweja, UBS’ global head
of emerging markets cross asset strategy, wrote in a client note.
“The trade hit scenario is not being priced in at all.”

That’s because it’s been stabilized by technical factors
such as cash drawdowns and low supply, according to UBS. But the
firm also says those two drivers are unlikely to persist
going forward, which would mean more vulnerability to fundamental
drivers like a mounting trade war.

That’s bad news for investors enjoying the placidity because, in
an environment devoid of technical backstops, trade conflict is
actually a big deal for credit — and can be quite harmful.

“Trade tariffs can affect speculative-grade credit via lower
profits, higher asset price volatility and tighter lending
conditions,” Baweja said.

Let’s break down UBS’ two trade-escalation scenarios — one that’s
relatively modest, and one that’s more extreme:

Scenario 1 (modest) — 
Modest haircut on 2018 real US GDP (3.1% to
2.7%), ISM manufacturing of 55, no change in stock returns/equity
volatility

• This would push US high-yield
  spreads to 429 basis points (fair value, currently 350)

Scenario 2 (extreme)
—

 Larger
reduction of 2018 real US GDP (3.1% to 2.1%), ISM manufacturing
of 54, negative shock to equity markets (11% drop in S&P 500, Cboe Volatility Index
(VIX) up to 29)

• This would push US high-yield
  spreads to 545 basis points (fair value, currently 350)

UBS

With all of that established, the question becomes: How can
investors get ahead of this? UBS offers a handful of
recommendations, organized by both credit quality and industry
grouping.

Credit
quality

• Favor double-B high-yield assets
  over single-B
• Overweight triple-C assets

Industry grouping

• Overweight energy — “Oil prices are underpinned by
  fundamentals and higher quality financials,” Baweja said. “We
  expect these to outperform through the cycle.”
• Underweight tech — This is “due to tariff risks and
  excessive debt growth this cycle.”
• Underweight industrials and metals/mining
• Underweight non-cyclicals (consumer
  staples/healthcare) — “The dual build-up in corporate leverage
  and in their end (lower income) consumers pose material
  amplification risks this cycle that will trigger unexpected
  fallen angels and defaults.”