26-03-2024 · Quarterly outlook

Credit outlook: Race to the bottom

The ideal scenario for credit appears to be materializing, characterized by declining inflation and the likely avoidance of a recession. However, have market participants grown complacent, with risk appetite reaching high levels?

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    Authors

  • Sander Bus - CIO High Yield, Portfolio Manager

    Sander Bus

    CIO High Yield, Portfolio Manager

  • Reinout Schapers - Portfolio Manager

    Reinout Schapers

    Portfolio Manager

While we acknowledge the high probability of the consensus scenario, we remain mindful of the fragility of sentiment and the omnipresence of risks in a changing world. With current tight valuations and risk positioning, there is ample room for disappointment.

We maintain a neutral positioning in investment grade and emerging markets, focusing on generating alpha through issuer selection. Within high yield we firmly adhere to our quality bias, resulting in a beta below 1. We do not view this as the optimal time to increase beta through a derivatives overlay, as CDS is trading even tighter than cash markets.

We do not view this as the optimal time to increase beta

Fundamentals

We believe it is crucial to consider economic scenarios rather than simply positioning for a single base case. Over the last year the market consensus has shifted between the three main scenarios for the US economy: hard landing, soft landing and no landing. In early 2023, a US recession was the prevailing market consensus. This shifted towards a soft landing during the summer, then to a no landing ('higher for longer') consensus by October. By the end of 2023, sentiment had firmly reverted to the soft landing scenario, which remains the predominant view in the market to date.

Looking beyond the United States, the global landscape presents a starkly different picture. China is still experiencing pronounced weakness, marked by the collapsed housing market that continues to dampen sentiment. Unemployment rates are climbing, and deflationary pressures remain. The end is not in sight with money growth decelerating once again, despite efforts by the Chinese authorities to turn the tide.

The European economy has also stagnated in 2023, largely due to a faster monetary policy transmission, higher energy prices, lower fiscal impulse and more sensitivity to developments in China. This is particularly evident in German manufacturing, which is bearing the brunt of the economic strain. For a more extensive view on the macro outlook, we refer you to the outlook from Robeco’s Global Macro team: Risk-on, but not gone.

Valuations

So, is there still value? We would argue that while spreads are very tight, European investment grade and financials still present reasonable value relative to other markets. Although financials have tightened considerably in absolute terms, they still appear attractive when compared to corporate counterparts on a relative basis. We maintain that the long-term investment thesis for financials remains intact, given the improvements in capital ratios, liquidity, and funding since the global financial crisis. Additionally, another area of value lies within the semi-government and agencies (SSAs) segment of the market. Despite the tightening of swap spreads, these instruments continue to trade attractively and have even widened compared to swap yields.

The long-term investment thesis for financials remains intact

Technicals

Demand for credit has been robust, as evidenced by significant inflows into credit strategies from both institutional and retail investors. We have observed this trend and have also heard anecdotal evidence of continued inflows into fixed maturity products. Additionally, there is demand for long-dated credit from insurance companies that provide bulk annuities to corporate pension schemes. However, this strong demand is met with equally strong supply in the investment grade markets. Both the European and US investment grade markets have expanded as a result.

In contrast, the high yield market has experienced contraction due to a combination of companies leaving the universe following upgrades, and refinancings outside of public markets. This disparity between demand and supply is one of the factors contributing to the outperformance of high yield. A similar narrative applies to hard currency emerging markets, where the market has also shrunk as companies found alternative funding avenues such as local currency markets.

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Strong demand is met with equally strong supply in the investment grade markets

The strong demand for credit is also reflected by pricing dynamics in the new issue market. Issuers can print new deals almost without any price concession while books are often multiple times oversubscribed. Central bank monetary policy can also have a significant impact on market technicals. The reduction of balance sheets is ongoing, however, the volume of fixed income instruments on the balance sheets of the Fed and ECB remains substantial. The most negative scenario for credit would be if the anticipated rate cuts were not delivered. This could happen if inflation reaccelerates.

Conclusion

As long as we are in an environment where rate cuts are more likely than not, we judge that the technical support from central bank policy remains constructive. However, we should not anticipate another round of spread tightening after the initial rate cut. Historical data shows that even in a soft landing environment, spreads typically do not tighten further following the first rate cut.

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