singaporeen
Credit outlook: The mess after the largesse

Credit outlook: The mess after the largesse

28-06-2022 | Insight
We have seen a very significant repricing of fixed income, but panic and volatility can also provide opportunities.
  • Sander  Bus
    Sander
    Bus
    Co-head Credit team
  • James Stuttard
    James
    Stuttard
    Head of Global Macro team and Portfolio Manager
  • Victor  Verberk
    Victor
    Verberk
    CIO Fixed Income and Sustainability

Speed read

  • Inflationary pressure has accelerated and risks to growth are increasing
  • A horrendous start to the year has resulted in much improved valuations
  • Debt levels have never been higher and the safety net has been removed

US Treasuries this year had their worst January-to-April period since 1788. On top of that, credit spreads widened. By all standards, we have seen a very significant repricing of fixed income. The world looks grim and it would be easy to extrapolate the bear market. But panic and volatility can also provide opportunities.

We already see a few pockets of the market that are starting to look attractive. Investment grade looks cheap at these levels and investors able to withstand the volatility and who are prepared to take a longer investment horizon could start buying. High yield is not there yet, although we believe that the quality names in high yield already look attractive.

How did the world get into this mess? “The policy response to Covid-19 seemed like a great cure during the health crisis, but the combination of massive fiscal and monetary stimulus now turns out to have been an over-extension of an era of largesse that is one of the key ingredients for the disease called inflation,” says Sander Bus, Co-head of Robeco’s Credit team.

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Trouble ahead

While many parts of the economy are still red-hot, leading indicators are increasingly pointing to recession risk. Consumer confidence, producer confidence, inverted yield curves and housing affordability all indicate that trouble is coming. This should not be a surprise given the aggressive monetary tightening that we are now seeing in response to raging inflation.

Central banks currently have no option other than to tighten financial conditions further in order to slow their economies and restore the demand-supply balance. Clear evidence of inflation coming down is needed before they can stop tightening. The chances that inflation pressures would somehow simply disappear of their own accord are slim.

That had been what policymakers hoped for when they still used the word ‘transitory’ in 2021. But the ‘t’ word has been long canceled. “If history since 1955 is a guide, we have to conclude, as Larry Summers and Alex Domash first posited, that from current levels of inflation and labor market overheating, Fed tightening has always resulted in a recession,” says Jamie Stuttard, Robeco Credit Strategist.

Inflation is overshooting

Inflation is overshooting in the US and in Europe, while it remains a bit more moderate in China. In the US, it is most clear that the key trigger was excess fiscal stimulus at a time when the output gap had already closed. In Europe, there is also an element of too much fiscal spending, and on top of that a food and energy crisis on the back of the war in Ukraine, together with imported inflation via the foreign exchange channel.

Inflation has caused a shock to real incomes not seen in the US since the 1970s. This, coupled with the sharp tightening in financial conditions, with the fragile China macro backdrop to boot, implies a real risk of recession in our view. There are more parallels to the 1970s episode. Policymakers at that time also argued that inflation was transitory since it was initially triggered by external shocks.

Even though they were all temporary shocks, together they caused individuals to expect higher inflation, entrenching the inflationary dynamics further and contributing to a self-reinforcing spiral of wage-price inflation. We do not see inflation spiraling out of control yet, but it is a scenario that central banks are desperate to avoid, given this type of inflation can be very difficult to fight.

Healthy corporates, but check the debt levels

Corporate profit margins are at cyclical highs, which is not uncommon on the eve of an economic slowdown. Corporates enjoyed strong pricing power in 2020 and 2021, with supply constraints and government support helping to lift margins. Earnings are 20-40% above 2019 levels in all key regions.

One important element to judge corporate health is to look at companies’ interest rate sensitivity. Companies that have high gearing and a lot of floating-rate debt on the balance sheet are clearly more vulnerable.

For Europe, the situation is even more challenging given the gas squeeze and terms of trade developments that have lifted gas and electricity prices in euro terms to very elevated levels. The overhang of the energy crisis is negative for Europe but at the same time will constrain the ECB from lifting rates as aggressively as the Fed.

Since we have overweight positions in European banks and many clients have the global financial crisis still top of mind, we think we should make some remarks about this segment. During Covid, a substantial amount of SME credit risk was shifted from bank balance sheets to government entities via the use of state-backed loans. This tool was used mainly in southern Europe, with Italy now having more than 10% of GDP in state-backed loans.

This means that when defaults increase, banks are partly shielded as some losses will end up at the government. According to Victor Verberk, Co-head of the Robeco Credit team, “We conclude that healthy capital positions and probably lower credit losses compared to earlier episodes of economic stress should help banks to weather the storm. We feel comfortable that banks will not be the epicenter of stress in the next recession”.

Valuations are becoming more attractive

Spreads on all segments of the credit market are now undoubtedly above median spreads. Euro investment grade and Euro high yield have even reached top quartile.

Market cycle | Mapping our view on market segments

Source: Robeco, June 2022

For investment grade, we have reached levels where we feel comfortable running portfolio betas just above 1. For high yield and emerging debt portfolios we have reduced the underweight beta as well, but are not yet in positive territory for all portfolios.

We are more cautious on high yield than on investment grade. The ratio between high yield and investment grade spreads is tight by historical standards, which leaves room for underperformance of high yield on a risk-adjusted basis. “We believe that the lower end of the credit spectrum is particularly vulnerable. A recession will increase idiosyncratic risk and dispersion in this segment. This is still insufficiently priced,” says Bus.

The technicals are tough

Central bank policy is clearly the dominant driver of asset prices this year. There is much uncertainty about the amount of monetary tightening required to achieve price stability and a return of inflation rates back down to mandated targets, without overshooting into deflation. This uncertainty is creating very high volatility in fixed income markets.

During the sell-off this year we saw days that reminded us of March 2020 and September 2008, with very poor liquidity conditions. It is also a reminder that investment bank balance sheets are not the same as before the global financial crisis. More regulation, more stringent risk management and a lower appetite for physical inventory means investment banks are unable to act as a shock absorber.

This is why we see liquidity rapidly deteriorating in markets where everyone is looking for the exit. “It once again stresses the importance of being contrarian in these markets,” says Verberk. “One can be wrongfooted by aggressive bear market rallies and should try to take risk when most people let go – and vice versa. Market liquidity is very fragile, and one should use that to your benefit.”

Conclusion

All in all, valuations suggest a somewhat more constructive stance to credit markets, but at the same time fundamentals and technicals are still weak. During QE we learnt not to fight the Fed – and the same holds this time around during tightening. The Fed is combatting inflation, and market weakness is collateral damage that they are accepting. Spreads could very well widen even more, at which point we will consider increasing the beta further.

“Recession risk has increased and the market has moved towards that scenario as well,” says Bus. “Nevertheless, we are not yet in the phase of capitulation and unjustified cheapness. These opportunities might very well occur in the next three to six months.“

Leave your details and download the publication

Disclaimer

I agree to the Robeco Disclaimer and the collection and use of my personal data by Robeco, for the purposes for which such data is collected and used as set out in the Privacy Policy,  including for the purpose of direct marketing of Robeco products or services. Your data will be treated with utmost care and will not be passed on to third parties.

Important information

This information is for informational purposes only and should not be construed as an offer to sell or an invitation to buy any securities or products, nor as investment advice or recommendation.
The contents of this document have not been reviewed by the Monetary Authority of Singapore (“MAS”). Robeco Singapore Private Limited holds a capital markets services license for fund management issued by the MAS and is subject to certain clientele restrictions under such license.
An investment will involve a high degree of risk, and you should consider carefully whether an investment is suitable for you.

Logo

Important Information

Warning/Important note: This website contains information which is only available to qualified investors as defined below. If you are not a qualified investor, please click “I Disagree” to leave the website.

By clicking on "I agree", I declare that: 

  • I am a qualified investor as defined under 1
  • I have read and understood the Terms and Conditions and Disclaimers as described under 2

1 - This website may only be accessed directly or indirectly by the following persons in Singapore:

1) “institutional investor” under section 304 of the Securities and Futures Act (Cap.289)(“SFA”), which means:
(i) the Government; (ii) a statutory board as may be prescribed by regulations made under section 341 of the SFA; (iii) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is (A) to manage its own funds; (B) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or (C) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country; (iv) any entity (A) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and (B) whose funds are managed by an entity mentioned in sub-paragraph (iii); (v) a central bank in a jurisdiction other than Singapore; (vi) a central government in a country other than Singapore; (vii) an agency (of a central government in a country other than Singapore) that is incorporated or established in a country other than Singapore; (viii) a multilateral agency, international organisation or supranational agency as may be prescribed by regulations made under section 341 of the SFA; (ix) a bank that is licensed under the Banking Act (Cap.19); (x) a merchant bank that is approved as a financial institution under section 28 of the Monetary Authority of Singapore Act (Cap.186); (xi) a finance company that is licensed under the Finance Companies Act (Cap.108); (xii) a company or co-operative society that is licensed under the Insurance Act (Cap.142) to carry on insurance business in Singapore; (xiii) a company licensed under the Trust Companies Act (Cap.336); (xiv) a holder of a capital markets services licence; (xv) an approved exchange; (xvi) a recognised market operator; (xvii) an approved clearing house; (xviii) a recognised clearing house; (xix) a licensed trade repository; (xx) a licensed foreign trade repository; (xxi) an approved holding company; (xxii) a Depository as defined in section 81SF of the SFA; (xxiii) an entity or a trust formed or incorporated in a jurisdiction other than Singapore, which is regulated for the carrying on of any financial activity in that jurisdiction by a public authority of that jurisdiction that exercises a function that corresponds to a regulatory function of the Authority under this Act, the Banking Act (Cap.19), the Finance Companies Act (Cap.108), the Monetary Authority of Singapore Act (Cap.186), the Insurance Act (Cap.142), the Trust Companies Act (Cap.336) or such other Act as may be prescribed by regulations made under section 341 of the SFA; (xxiv) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere; (xxv) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors; (xxvi) the trustee of such trust as the Authority may prescribe, when acting in that capacity; or; (xxvii) such other person as the Authority may prescribe.

2) “relevant person” under section 305(1) of the SFA, which means:
(i) An accredited investor; (ii) a corporation the sole business of which is to hold investments and the entire share capital of which is owned by one or more individuals, each of whom is an accredited investor; (iii) a trustee of a trust the sole purpose of which is to hold investments and each beneficiary of which is an individual who is an accredited investor; (iv) an officer or equivalent person of the person making the offer (such person being an entity) or a spouse, parent, brother, sister, son or daughter of that officer or equivalent person; or (v) a spouse, parent, brother, sister, son or daughter of the person making the offer (such person being an individual).

3) any person who acquires the units [in a collective investment scheme] as principal if the offer is on terms that the units may only be required at a consideration of not less than $200,000 (or its equivalent in a foreign currency) for each transaction, whether such amount is to be paid for in cash or by exchange of units in a collective investment scheme, securities, securities-based derivatives contracts or other assets, and if the following condition is satisfied: (i) the offer is not accompanied by an advertisement making an offer or calling attention to the offer or intended offer; (ii) no selling or promotional expenses are paid or incurred in connection with the offer other than those incurred for administrative or professional services, or by way of commission or fee for services rendered by any of the persons specified in section 302B(1)(d)(i) to (vi) of the SFA; and (iii) no prospectus in respect of the offer has been registered by the Authority or, where a prospectus has been registered (A) the prospectus has eAccxpired pursuant to section 299 of the SFA; or (B) the person making the offer has before making the offer 1. informed the Authority by notice in writing of its intent to make the offer in reliance on the exemption under this subsection; and 2. taken reasonable steps to inform in writing the person to whom the offer is made that the offer is made in reliance on the exemption under this subsection.

4) Or otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA.

If you are not any of the types of persons described above, you are not authorized to enter this website and you should leave this website immediately.

2 Terms and Conditions
You acknowledge that you have read these Terms and Conditions (“Terms”) prior to accessing the website located at www.robeco.com/sg (“Website”) and you agree to be bound by the Terms.  If you do not agree to all of the Terms, you are not an authorised user and you should not use the Website. The Website is owned by Robeco Singapore Private Limited (company registration number: UEN. 201541306Z), which is licensed by the Monetary Authority of Singapore (“MAS”) pursuant to the Securities and Futures Act (Cap.289) (“SFA”) of Singapore, and is managed by Robeco Singapore Private Limited and/or its affiliates (collectively, as “Robeco”). The Website is intended for and should be accessed by institutional investors or accredited investors (as defined under Section 4A of the SFA) of Singapore.  The Website is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject the Robeco to any registration or licensing requirement within such jurisdiction.  It is your responsibility to observe all applicable laws, rules and regulations of any relevant jurisdiction. The content contained in the Website is owned by Robeco and/or its information providers and is protected by applicable copyrights, trademarks, service marks, and/or other intellectual property rights.  You may not copy, distribute, modify, post, frame or link the Website, including any text, graphics, video, audio, software code, user interface, design or logos.  You may not distribute, modify, transmit, reuse, repost, or use the content of the Website for public or commercial use, including all text, images, audio and/or video.  Robeco may terminate your access to the Website for any reason, without prior notice. Neither Robeco, nor any of its associates, nor any director, officer or employee accepts any liability whatsoever for any loss arising directly or indirectly from the access of the Website.  You agree to indemnity and hold Robeco, its associates, directors, officers or employees harmless against any and all claims, losses, liability, costs and expenses arising from your use of the Website due to violation of the Terms. Robeco reserves the right to change, modify, add or remove any parts of the Terms at any time and for any reason.  The Terms shall deemed to be effective immediately upon posting. The Terms shall be governed by, and shall be construed in accordance with, the law of Singapore.

Disclaimers
The Website has not been reviewed by the MAS. Accordingly, the Website may not be accessed directly or indirectly to persons in Singapore other than (i) to an institutional investor under Section 304 of the SFA, (ii) to a relevant person pursuant to Section 305(1), or any person pursuant to Section 305(2), and in accordance with the conditions specified in Section 305, of the SFA, or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. 

Nothing in the Website constitutes tax, accounting, regulatory, legal or investment advice.  The Website is for informational purposes only and should not be construed as an offer to sell or an invitation to buy any securities or products, nor as investment advice or recommendation or for the purpose of soliciting any action in relation to Robeco’s businesses, or solicitation by anyone in any jurisdiction in which such an offer or solicitation is not authorised or to any person to whom it is unlawful to make such an offer and solicitation. Any reproduction or distribution of information from the Website, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited.  By accessing to the Website, you agree to the foregoing.  

The funds referred to in the Website are for information only.  It is not a recommendation or investment advice, nor does it mean the funds is suitable for all investors.  The contents of the website is not reviewed by the MAS.  Any decision to participate in the funds should be made only after reviewing the sections regarding investment considerations, conflicts of interest, risk factors and the relevant Singapore selling restrictions.  You should consult your professional adviser if you are in doubt about the stringent restrictions applicable to the use of the Website, regulatory status of the funds, applicable regulatory protection, associated risks and suitability of the funds to your objectives.

Any decisions made based on the information contained in the Website are the sole responsibility of yours.  Any investments made or to be made shall be with your independent analyses based on your financial situation and objectives.  The investments and strategies contained in the Website may not be suitable for all investors and are not guaranteed by Robeco.  

Investment involves risks and may lose value.  Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future.  The value of your investments may fluctuate.  Past performance is no indication of current or future performance.  The Website may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies and such projection or forecast is not indicative of the future.  The information contained in the Website, including any data, projections and underlying assumptions are based upon certain assumptions, management forecasts and analysis of information available on an “as is” basis and without warranties of any kind, whether express or implied, and reflects prevailing conditions and Robeco’s views as of the date published or indicated, and maybe superseded by subsequent events or for other reasons.  The information contained in the Website are accordingly subject to change at any time without notice and Robeco are under no obligation to notify you of any of these changes.  Robeco expressly disclaims all liability for errors and omissions in the information presented in the Website and for the use or interpretation by others of information contained in the Website.

Robeco Singapore Private Limited holds a capital markets services licence for fund management issued by the MAS and is subject to certain clientele restrictions under such licence.  An investment will involve a high degree of risk, and you should consider carefully whether an investment is suitable for you.

I Disagree