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Credit Insights

Corporate Bonds Weaken on Concerns That Trade War May Expand to New Fronts

Investors sold risk assets and headed to the safe havens.

Slowing economic growth and the potential expansion of the trade war to a second front were more than enough to convince investors to sell risk assets and head to the safety of U.S. Treasury bonds. While most economic metrics continue to indicate that the economy is expanding, recently released economic indicators such as Markit's Composite Purchasing Managers Index have been dropping. While a level above 50 does indicate economic growth, the PMI reading for May dropped to 50.9 (a 36-month low) from 53.0 last month. The deceleration appears to be widespread as both the services and manufacturing components fell. According the Federal Reserve Bank of Atlanta's GDPNow model estimate for real GDP growth, the seasonally adjusted annual rate for GDP growth in the second quarter is currently only 1.2%. The GDPNow model estimate had been as high as 1.7% at the beginning of May.

While U.S. economic growth appears to be slowing, there are also indications that the economy in China may not be as stable as believed. For example, reported loan losses in China continue to be very low, but for the first time in over 20 years, the government took control of a failing regional Chinese bank. After this bank was placed into receivership, short-term funding costs for other regional Chinese banks rose across the country as regional banks reassessed the Chinese government's willingness to continue to backstop individual banks.

While trade negotiations between the United States and China have been an overhang on the asset markets for several weeks, the potential for the trade war to spread to other fronts further pressured the markets. Last week, President Donald Trump advocated for a 5% across-the-board tariff on imports from Mexico if the Mexican government does not take steps to halt illegal immigration to the U.S. The tariff would continue to increase if steps are not taken. According to The Wall Street Journal, the tariff could be applied to $360 billion of imports, of which $125 billion consist of automobiles and parts.

In the investment-grade market, the average credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) widened 6 basis points to +132 basis points last week. In the high-yield market, the ICE BofAML High Yield Master II Index widened 43 basis points to +459. It was a similar story in the U.S. equity market, where the S&P 500 fell 2.62% for the week.

While corporate credit spreads widened out and equity markets sold off, Treasury bonds and high-quality sovereign bonds played their typical safe-haven role and traded higher as investors looked to escape the volatility in risk assets. In the U.S., as bond prices surged higher, interest rates dropped 18-24 basis points across the yield curve, with the 2-, 5-, 10-, and 30-year bonds dropping to 1.92%, 1.91%, 2.12%, and 2.27%, respectively. These are the lowest yields at which Treasuries have traded since 2017.

In Europe, negative interest rates were not enough to dissuade investors from flocking to the perceived safety of Germany's sovereign bonds, as prices rose enough to push Germany's 5-year bond to an even greater negative yield of 0.58% (only 4 basis points from its prior record low) and the yield on the 10-year bond declined to a negative 0.20% (a record low). However, Italian sovereign bonds continued to weaken after Italy's deputy prime minister, Matteo Salvini, said he is willing to breech the European Union's deficit limits to prop up the Italian economy. The credit spread between Italy's 10-year bond and Germany's 10-year bond widened to +287 basis points, its widest level since December last year.

Weekly High-Yield Fund Flows
Investors pulled $1.5 billion out of the high-yield asset class last week. Outflows were led by net unit redemptions of $0.9 billion across high-yield exchange-traded funds and $0.6 billion of redemptions from high-yield open-end funds. After strong inflows earlier this year, recent outflows have reduced total inflows to the high-yield asset class to $11.8 billion year to date, consisting of $7.3 billion worth of net unit creation among high-yield ETFs and $4.5 billion of inflows across high-yield open-end mutual funds. Including the outflows registered late last year, over the past 52 weeks, total outflows equal $5.7 billion, driven by $6.4 billion of withdrawals across open-end mutual funds, partially offset by $0.7 billion of net unit creation among high-yield ETFs.

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