In the context of a synchronized slowdown in global growth and the rise of geopolitical risks, the major central banks are engaged in easing programs that are disjointed. This has created an increasingly uncertain outlook for asset prices, including in the global credit markets. The divergent risk environment is already being reflected in the large differential in performance this year of lower-quality US high yield spreads, US levered loans and even in emerging markets sovereign assets in hard currency (Figure 1).
Considering these uncertainties into 2020, we analyzed global spread markets in order to outline scenarios and to evaluate probability-weighted outcomes. The main purpose of this exercise was to gauge what scenarios markets are pricing in, and to have an educated discussion about assumptions and probabilities.
Based on observations from our scenario analysis of global spread markets, our base case is that we will stay in a low-growth and low-inflation environment. The second most likely scenario is that of a technical US recession. Our analysis shows that different spread markets currently are pricing in a 20-25% probability of a recession. The least likely scenario is one in which growth recovers and inflation rises meaningfully.
In general, for credit investors, the two scenarios that can be considered positive are inflation and growth moving back to trend levels, and our base-case scenario of low growth and low inflation, in which a recession is avoided and monetary policy stays extremely accommodative.
A scenario in which growth and inflation are above trend is slightly positive for spreads, since there is still compression potential. Nevertheless, it carries the risk of global monetary policy turning less accommodative again.
If we assume that probabilities are weighed towards a recession in the US, and in particular to a replay of a recession such as we saw in 2000-2001, our view is that spreads in all credit sectors on a probability-weighted basis ought to be wider than current levels. More specifically, we expect that euro- and US dollar-denominated investment grade credit would experience the least widening in spreads, while US high yield, euro high yield bonds, and the CDS High Yield indices would be the worst off.
Our analysis did not include a crisis scenario such as the Global Financial Crisis. Given the concerns over the buildup of non-financial corporate debt in the US, we deem the late 1990s to be a stronger parallel to the current environment than the conditions that prevailed in 2008. Furthermore, with the ECB purchasing non-financial corporate bonds as part of the QE program again, the positive technicals of the program and secondary effects in euro spread across the ratings spectrum should help decrease the downside technical risks for euro spread markets compared to their US dollar counterparts.
These probability-weighted scenarios are confirmation of our preference to be focused on quality in credit markets, to be selective about exposure to idiosyncratic risks in high yield, and to maintain credit betas at market-neutral levels.
This view is consistent with the conclusions from our Credit Quarterly Outlook and our Fixed Income Outlook. We discussed in those publications the importance of quality and sector rotation, along with safe-haven positioning in the later stages of the extended credit cycle. This is especially applicable after a so-called ‘sugar rush’ and given warning signs of excesses in the global leverage finance markets.
Considering the relatively short spread history in certain spread markets, there is some subjectivity in our calculations. Another caveat in our analysis is that, given that there is little historical precedent for the current low or negative yield environment, we may now be underpricing the spread market premium for anything with carry or positive yield.
Given our estimated probabilities and the continued uncertainties, our preference is to maintain an emphasis on quality spread assets with higher Sortino ratios1 in our global macro strategies. Our exposure to credit and emerging markets has become more selective, and we prefer an overall market-neutral stance. This analysis also confirms the divergence in performance in lower-quality, below-investment grade spreads and emerging market spreads, and we believe this divergence theme will continue into the new year. For now, quality reigns.
1 The Sortino ratio is a risk measures that evaluates returns for a given level of downside risk. It is measured as the return relative to the risk-free rate, divided by the standard deviation of the negative returns. It is a variation of the Sharpe ratio, which considers returns relative to total risk.