The US ISM manufacturing index (Chart 1) has sharply declined after reaching a three-year high in mid-2014. In January, it ticked up to 48.2, but remains near the lowest reading since June 2009, indicating an outright contraction in the manufacturing sector. Importantly, this is commonly associated with a recession. Meanwhile, the non-manufacturing index (covering the services sector) has declined recently, but remains in expansion mode at over the level of 50.

Chart 1: US Purchasing Manager Indices

Chart 1: US Purchasing Manager Indices

Source: Bloomberg, through January 2016

The weakness of the manufacturing sector is also observable in "hard data," such as US industrial production, which despite January's uptick, has been in a strong declining trend. Moreover, weakness in the manufacturing sector is not only a US phenomenon, but rather a global theme. In particular, the Chinese manufacturing index (Chart 2) fell into recessionary territory this summer. Here too, however, the non-manufacturing index (covering the services sector) remains firmly in expansion mode.

Chart 2: China Purchasing Manager Indices

Chart 2: China Purchasing Manager Indices

Source: Bloomberg, through January 2016

Although above the important level of 50, the European Markit Manufacturing PMI Index (Chart 3) declined significantly in January, and has underperformed its service sector equivalent by a significant margin since last summer. In our view, household expenditure in Europe has taken over from investments and exports as the driving force behind corporate revenue growth.

Chart 3: Eurozone Markit Purchasing Manager Indices

Chart 3: Eurozone Markit Purchasing Manager Indices

Source: Bloomberg, through January 2016

Thus, the strength of the service sector clearly is the major factor behind global economic growth. In the US, a strong labour market, rising real estate valuations, low commodity prices and interest rates are having positive impacts on consumer spending, which accounts for more than two-thirds of economic activity. Moreover, the above mentioned factors are also having positive implications for the economies of other regions, like Europe.

The tailwind for the sector can be also observed in the 2015 spread performance of service companies (Chart 4). The widening of credit risk premiums for service orientated issuers, i.e. banks and transportation, were much more moderate than price movements in the manufacturing sector, in which basic industry and energy companies had a very difficult year in particular.

Chart 4: Spread Changes in 2015 in basis points

Chart 4: Spread Changes in 2015 in basis points

Source: Bloomberg

So far in 2016, the same negative forces from last year, namely weak growth in China and declining commodity prices, are continuing to impact the manufacturing sector and will likely continue to do so in the coming months. This should have important implications for portfolio positioning and a focus on the service sector credits should, in our view, pay off this year just as it did last year.

The largest group of service providers in the global corporate bond indices are banks. Banks continue to adjust their business to a highly regulated operating environment and, therefore, remain, despite recent volatility, a safe place for bond investors. Banks are moving away from balance sheet-heavy businesses model towards a capital-lite model, such as private banking. The changes in the business model, on one hand, are impacting banks' profitability, but on the other hand, are reducing earnings volatility and creating interesting opportunities for bond investors. In addition, regulatory pressure will force banks to continue to increase their capital ratios and create a solid cushion for bondholders. For this reason, we believe that excellent investment opportunities exist in the banking sector.

Beside banks, other service oriented issuers also look interesting. Real estate companies have benefited from the strong recovery in asset prices after the global financial crisis, driven by low interest rates and improving occupancy rates, as global economies emerged from recession. Furthermore, the pool of opportunities of real estate bonds has grown substantially as companies have reduced their reliance on bank funding and securitization by increasingly issuing corporate bonds. In particular, issuers focused on wholesale distribution centres look attractive.

Furthermore, transportation bonds showed stability last year, as their cash flows are often linked to toll roads and airport concessions, as well as fees for the usage of telecom towers. These cash flows are often highly predictable and offer stability for issuers when global growth is slowing. However, transportation companies also can benefit from the backdrop of a growing economy, as seen in Europe, in the aftermath of the global financial crisis.

Solid fundamentals are not the only factor that make service-related issuers attractive. They also offer stability to portfolios as markets suffer from an increased level of volatility. In the recent turmoil (Chart 5), service companies, except for financials, once again outperformed manufacturing sectors, especially energy and basic materials.

Chart 5: Spread Changes in 2016 in basis points

Chart 5: Spread Changes in 2016 in basis points

Source: Bloomberg, through January 2016

Conclusion

In sum, beside other attractive investment themes that we highlighted in a recent publication (http://en.nikkoam.com/articles/2015/10/what-investment-themes-will-drive-credit-markets) , we foresee the overweighting of service-related issuers as a core theme for 2016. Importantly, however, recent experience has shown that even Tier 1 banks can come under pressure if bad quarterly results spark fears about coupon cancellations and recently, a once high-flying Spanish infrastructure provider has slid into bankruptcy. Consequently, promising investment themes must always be combined with bottom-up research.