As our Global Macro team explained in their September 2022 outlook, ‘Twin Peaks’, in a hiking cycle that ultimately ends in recession, rates typically peak before credit spreads do. In particular, rates usually peak around the second-to-last Fed hike.
“We believe we are now in the valley between the two peaks,” says Sander Bus, Co-head of the Robeco Credit team. “Rates have started to come down and may have peaked in some markets, while inflation is now easing. Credit spreads have also rallied a lot since mid-October but are set to rewiden when markets start anticipating a recession that would hit corporate health.”
As the probability of a recession rises and becomes part of the consensus view, market dispersion will increase. The lower-quality end of the credit spectrum is likely to see an increased default rate while the higher end of the market could benefit from lower rates and a flight to quality.
Once recession is fully priced in and spreads reach their own peak, that would be the time to go outright long, even in high yield. Typically, that point is reached well before default rates have peaked.
With increased supply of European government bonds we expect Euro swap spreads to tighten further. Since swap spreads are a large part of the total credit spread for Euro investment grade, we are comfortable with a modest long position in Euro investment grade markets while being much more cautious towards other markets that are trading tight, given where we are in the cycle.
A recession likely in the US and Europe
“Our base case is that the US as well as Europe will experience recession in 2023,” says Victor Verberk, Co-head of the Robeco Credit team. “Although we expect the recessions to play out in the same year and to be mutually reinforcing, the root cause will be different. The US is likely to experience a classic boom-bust cycle, whereas the European recession will be driven largely by an energy supply shock.”
The Fed and the ECB are determined to keep monetary policy tight until they see confirmation that inflation will reach their target. The good news is that inflation has started to moderate, which means the end of the hiking cycle is in sight. But that does not mean the Fed is anywhere close to cutting rates.
They will keep an eye on the labor market in particular, wanting to see signs that wages are coming down to more normal levels and that are consistent with the inflation target. That might only be possible if unemployment were to rise, which in turn requires a recession.
China is in a different phase. It has just abandoned its zero-Covid policy. Counterintuitively, the reopening can in the short run lead to less economic activity as the virus will spread rapidly and consumers will self-impose reduced mobility. But a recovery of the Chinese economy is likely within a couple of months.
Can China regain its role as the locomotive that prevents the rest of the world from going into recession? We doubt it. The fiscal impulse in that market is simply not strong enough and China’s fiscal situation prevents it from ramping up spending the way it did in the past when the economy needed a boost.
The conclusion is that we have no reason yet to be positive about fundamentals.
Market rally has tempered our valuations assessment
The era of TINA (‘there is no alternative’) is definitely behind us. Even short-dated T-bills now provide a 4% yield, a level that a year ago could only be found in high yield markets.
The most attractive valuations can be found in European investment grade and especially in financials. This market offers spreads that are above median levels and it also trades cheap versus its US equivalent.
With a recession in developed markets being the base case, the key question is: what will recession do to the riskier parts of the credit market? When are spreads high enough to start buying? We know from the past that spreads typically peak before default rates peak.
Defaults rates have barely started their bearish phase, so it seems too early to start aggressively buying into high yield. High yield spreads are well below the 1000 bps level where they usually peak in recessionary environments.
With a higher-quality high yield market today, the default rate will probably end up being lower and hence the market spread will probably have a lower peak.
Figure 1 | The market cycle
Mapping our view on market segments
Source: Robeco, December 2022
Markets are very volatile and the valuation assessment can change quickly. In the middle of October there were more markets that looked attractive, but after the strong bear-market rally of the past six weeks our conclusion is that we had to lower our assessment of this pillar, with the exception of Euro investment grade.
Central banks are still driving markets
While the rates tightening cycle may be close to an end, the quantitative tightening cycle has only just begun. The Fed, the ECB and the BoE have started shrinking their balance sheets.
According to Bus, “the effect of quantitative tightening in the US will likely be indirect, as credit competes with the higher Treasury supply. In Europe, through the Corporate Bond Purchase Scheme (CBPS), the BoE has bought 5% of the sterling investment grade market, while the ECB owns 15% of Euro investment grade through the Corporate Sector Purchase Program (CSPP). With that demand gone, and now going into reverse, new buyers are urgently needed for credit products”.
A mitigating positive is the defensive positioning which seems to be consensus amongst credit investors, and the high cash balances in many investment portfolios.
The conclusion on technicals is that central banks are still driving markets. As long as central banks are still withdrawing liquidity from our market, the only conclusion we can draw is a cautious one.
The value of patience as we move into 2023
As the probability of a recession is increasing, more dispersion is likely in markets. The lower end of the credit spectrum could experience an increased default rate, while the higher end of the market could in due course benefit from lower rates and a flight to quality.
We therefore advocate up-in-quality strategies.
Once the recession is fully priced in and spreads reach their peak, it would be time to go outright long, even in high yield. Typically, that point is reached well before default rates have peaked.
Jamie Stuttard, Robeco Credit Strategist, concludes: “So, we believe we have seen the peak in rates fears and rates volatility, but credit volatility will linger, with a high likelihood of better entry moments in 2023. We just need to be patient.”