For economic advisors, imperfect information implies imperfect forecasts, which in turn complicates the process of forecasting economic activity. This is especially true right now. With so many distorting elements at play, we simply cannot rely on economic theory for easy answers. “As we consider all the evidence around corporate pricing power, policy stimulus and consumer spending behavior, we believe that US and European fundamentals will not be the key driver of credit markets in Q1 2022,“ says Victor Verberk, Co-head of the Robeco Credit team.
Regarding valuations, we have seen a back up in spreads. This started in Europe, while the US lagged somewhat. We believe the US credit market will catch up, as soon as everyone realizes we are in the same global boat when it comes to Covid. “There are also many risk factors that we believe are still not sufficiently priced, like geopolitical risks around Russia, the growth impact of the Chinese real estate meltdown, and emerging market volatility in general. Managing these risks with a contrarian research-driven attitude is more important than pinpointing the correct beta, if that already exists,” says Sander Bus, Co-head of the Robeco Credit team.
Technicals, and especially central bank activity and communication, might cause a bout of risk aversion after years of increased risk taking by asset owners. Hence the technical side of our assessment provided the most ammunition for discussion and we believe it will be the main reason to stay cautious for a while longer.
Humility is still the most appropriate term to use while assessing the economic prognosis. A few things are safe to state, though. Global manufacturing growth is solid enough despite the recent downward adjustment in growth estimations. Consumer goods demand continues to underpin growth. Actually, almost all growth has been driven by consumer demand. Capital investments and inventory build have so far hardly contributed. That might bode well for the future.
Most corporates are doing very well and profits are up. Rising input costs are increasingly a theme, but margins have held up well in general and it is clear most corporates are able to pass through rising input prices. “Meanwhile, the US labor market is tightening. With vacancies difficult to fill, the significantly lower labor force participation rate than in the pre-Covid era, a trend towards early retirement and some 2.5 million lost jobs since early 2020, the overall picture is a bit blurry – but the bottom line is that labor shortages are emerging,” says Jamie Stuttard, Robeco Credit Strategist.
A key source of concern for markets of course is inflation. Inflation prints have headed persistently higher. Despite central banks having been very firm that this would be transitory, more and more market participants no longer believe this. The Federal Reserve’s communication has not helped the cause, either. The most recent comments by Chairman Powell, that we should retire the word ‘transitory’ or change its definition, have not been productive. Efforts in recent years to convince markets that the Federal Reserve would deliberately be behind the curve, have come to naught after a few months of high inflation.
Also, the timing of these comments was odd, given that markets were simultaneously digesting the omicron news. It all points once again to our critical view of central bankers and the consequences of their behavior.
In Europe, it’s too soon to talk about rate hikes. But we do have to prepare for a wind down of PEPP at some stage. We think that the ECB would want to maintain some flexibility, though, and would keep the option to reinstate PEPP whenever they feel it is needed again. In all likelihood APP might even be expanded temporarily, to offset the end of PEPP. In other words, the ECB’s credit purchases will continue in some shape or form in 2022 – and the continued global portfolio rebalancing into risky assets is not over yet.
On fundamentals, our biggest concern is still on China. With 25% of GDP and 40% of domestic lending related to real estate, one cannot afford to be too easygoing about China’s property sector. There might be some fall-out into European banks, too. And while policymakers can mitigate the forces of contagion, resolution of the underlying imbalances can take years.
The conclusion is that, for a western developed market credit investor, the fundamentals will probably be fine. Despite the difficulties in estimating growth, and barring a major policy mistake from the Fed or a downward acceleration in China, fundamentals will probably not be the long-term driver for credit spreads beyond a tough winter. Inflation and central bank behavior and communication will determine sentiment and might drive short-term risk cycles. Our Global Macro team expects European inflation to peak in Q4 2021 and US CPI to peak in H1 2022, after which inflation is expected to moderate to just above central bank targets by the end of next year.
More than ever before, we are now investing in a world of imperfect information and imperfect foresight. This will drive market volatility and hence create opportunities for active managers.
Figure 1 | Market cycle: mapping our view on market segments Source: Robeco, December 2021
Source: Robeco, December 2021
Valuations have very recently eased a bit, as we have been expecting for some time. But markets certainly are not cheap yet. We still believe that risk factors have not been sufficiently priced. Geopolitical risks, inflation concerns, the China growth scare, energy prices or just general moves of nominal yields, all suggest that current spreads are not justified.
The conclusion on valuations is that we think credit spreads are still expensive. The limited widening that we have seen might deliver some stock-pick opportunities, though.
It could well be that some supply bottlenecks are here to stay for a good while yet, even if there have been incipient signs of easing. Longer term, Covid might become part of life, but its economic impact should dwindle over time. We mention this under ‘Technicals’, since a potential permanent impact on inflation remains a big question and the uncertainty premium on central bank behavior could be bigger. It also increases the chance of policy mistakes and market reactions to these mistakes.
“The conclusion is that technicals look weak. There are too many risk premia that are not well priced. This combined with the clear central bank hesitation in discerning the most appropriate path forward for policy, might prompt flows out of risky assets,” says Bus.
We have written about 2021 playing out as either a boring or bearish year. It turned out to be boring, with year-to-date EUR investment grade excess returns at 0%. That said, at the tail-end of the year it looks as though economic uncertainty is increasing, driven by unease around inflation. In our case, we would need to be convinced that we’re at the beginning of something bigger in order to justify increasing betas from the current underweight.
“We do see the opportunities opening up in selected emerging markets ex-China, as well as in financials, BB-rated credit, Euro swap spreads or Covid-recovery plays. We remain overweight EUR over US credit, given where valuations are. We would adjust this on any back up in the US credit market,” says Verberk.
Overall, it is important that, whatever we own, the risk should be reflected in the spread in this phase of the credit cycle.