Credit outlook: Common prosperity

In our previous outlook we used the word ‘humble’ when it came to forecasting the economy, given the degree of distortion and unpredictability created by the reopening process. Three months on, we still believe that humility is called for.

“Aside from the difficulty of making predictions in the current environment, one also wonders about their relevance,” says Sander Bus, Co-head of the Robeco Credits team. “Do fundamentals still matter in a world of financial repression, in which monetary and fiscal policymakers set the stage? It seems that markets have for years downplayed the role of fundamentals; one scenario in which the relationship between fundamentals and markets might return is when central banks loosen their grip. The key question for markets is therefore when that will happen.”

With spreads still near an all-time tight, a cautious positioning in credit markets makes sense to us. At the margin, we like financial institution credit more than other credit sub-sectors.

We feel that the entire market is so focused on inflation expectations that other potentially more important market drivers might be overlooked. “China has been the key engine of global growth for the last 15 years. With China now seemingly at a turning point we believe that it is probably more important than ever to monitor developments there closely,” says Bus.

The zero-Covid strategy was a success in 2020 but now feels more like a double-edged sword. The virus will continue to pop up and each time that happens the harsh containment measures hurt mobility and consumption. But, given that the service sector is most sensitive to lockdowns, compared to the more immune manufacturing sector, a purely Covid-induced Chinese slowdown would not hit the global economy as badly: China’s service sector is largely domestic and its products are non-tradable. However, sticking to this policy for too long will not help an economy that already has to deal with the impact of tighter regulation of its property market.

It is obvious that there is froth in the property market and that, given widespread moral hazard, tighter regulation was needed. For now, the uncertainty for the market is whether or not the authorities have overtightened and what the fall-out will be of an Evergrande restructuring.

The last overhang in China is the policy reset where the Chinese leadership wants to shift from outright growth to balancing growth with sustainability and social equality. This policy, labeled ‘common prosperity’, will be enacted gradually. There will be a tighter grip on some sectors, but this does not mean the end of private markets in China; these are simply too important for the economy.

Nevertheless, the shift will have serious repercussions on certain sectors such as big tech, gaming and tutoring. It is yet to be seen what this new policy means for China’s role as the world’s manufacturing hub should they succeed in the policy goal to raise low-income wages further and increase labor’s share in income. We note this contributes to Sustainable Development Goals (SDGs) 1, 2, 8 and especially 10. As a sustainable investment manager, we applaud the official ambition to strive for carbon neutrality by 2060.

Fighting climate change has rapidly become an important topic in capital markets, anyway. “The International Energy Agency estimates that achieving net zero emissions will require annual investments of around USD 5 trillion. Some economists see these large investments as a way out of secular stagnation, as growth and inflation are lifted. Also, on a micro level, we see that climate policies are playing an increasingly important role in companies’ strategies,” says Victor Verberk, Co-head of the Robeco Credits team.

Besides the potential slowdown in China, there are many other sources of uncertainty globally. First and foremost, we are still not out of the woods on Covid-19. The immediate Covid crisis seems to be over, but the virus still has the potential to derail the recovery, perhaps via further disruption to supply chains.

Inflation has been the main focus for markets and is extensively discussed in the Global Macro team’s quarterly outlook. All we want to say here is that the inflation debate will not be resolved in the coming months. It has the potential to cause some volatility, given the evident two-way risks. A key metric to watch is wage inflation, as this might give an indication on the persistence of inflation and tightness in labor markets. This holds for Europe as well as the US. Indications of more structural wage inflation would be important signals for the Fed and the ECB that it is time to speed up tightening plans.

Closely related to the inflation debate are the supply chain constraints plaguing many sectors. It started with semiconductors for the automotive industry but there are now shortages of many other inputs, such as containers, truck drivers, electricity and even raw materials for matrasses. Each has its own explanation, but the bottom line is that supply is falling short of demand. Most companies are able to pass on these higher costs as demand is robust across the board.

Spread markets have moved in a very narrow range during the last quarter. The exception is China high yield, where spreads have widened substantially on the back of the Evergrande issues and signs of weakness in the Chinese economy. Although we must admit that we were too early with our underweight beta position, we still feel comfortable holding on to this position. At current spreads the cost of running a small underweight beta is low.

The search for yield has resulted in very compressed markets where even troubled credits have performed well.

“For strategies that follow a winning-by-not-losing approach, this is not the easiest environment,” says Verberk. “For others, recovery or compression trades have become limited. Therefore, we continue to do our research on all individual holdings and prepare for the time that the market will distinguish again between the good and the bad.”