Credit outlook: This time is NOT different

Today, cautious positioning has moved to a net-long and many sell-side strategists have lowered their end-of-year spread forecasts. We argue that this is precisely the time to remain cautious. Economic laws have always applied, and this time should be no different. Investors should be wary when people claim the opposite. Historically, significant monetary tightening cycles have always resulted in a recession, only the time lag has differed. And this has been the sharpest rate rise in decades.

We do not have a crystal ball, however, in our assessment we believe that markets are currently too sanguine and complacent. The factors that caused the lag in monetary policy transmission have now largely played out. The savings reservoir is almost depleted, fiscal stimulus has reached its peak and the recovery of the services sector is complete.

Higher interest rates will soon start to bite the lower-rated companies, probably resulting in decompression between investment grade and high yield. Once central banks are finished hiking rates and rate volatility decreases, investment grade markets may well prove to be an attractive asset class compared to more risky assets.

We continue to hold the view that economic laws apply and that this hiking cycle will have similar consequences to those in the past. The only difference is that the policy lag is a bit longer. The longer lag can be explained by the imbalance that the world had to cope with after Covid: a high savings reservoir, catch up demand for services and large order backlogs in for example the auto sector. Additionally, fiscal support, especially in the US, has supported growth and employment. So, why do we think that the market is too complacent about the prospects of a soft landing? We believe the previously mentioned effects seem to have run their course.

Firstly, the US has benefited from outsized fiscal stimulus, however, from now on the fiscal impulse will be negative. Secondly, there is no additional upside from a further recovery in the services sector, and the service PMI’s dipping below 50 also indicates this. Thirdly, the consumer has depleted their excess savings and the very high perceived job security can only come down from this point. In other words, it is difficult to see continued strength in consumer spending, making it harder for companies to pass on input cost inflation moving forward.

To be clear, by no means does this suggest we expect a deep recession. We have not seen an overinvestment cycle; hence, we do not expect a decline in capex, which is usually symptomatic of deep recessions. Yet, we could see some collateral damage down the road, similar to what we witnessed in March this year during the US regional banking crisis.

Risk-free rates continued to move higher during the quarter, while credit spreads held in well or even tightened. Year to date, in high yield we saw compression across ratings with lower rated credit outperforming higher ratings. This reflects recession risk being priced out. We expect credit markets to start decompressing in the coming months as we believe that the market is currently underpricing the risk of a recession. We favor quality carry positions that still look attractive on a historical basis, and we would rather keep clear of the riskiest section of the markets that trade rich by historical measures.

Whilst technicals remain tough there are some positive indicators that suggest opportunities for investment grade bonds, as discussed in our recent webinar. With the end of the hiking cycle now in sight we are likely to see a period with lower rate volatility. A decrease in volatility paves the way for carry trades and investment grade would be the beneficiary. This environment also creates prospects for lower government bond yields which will benefit the total returns of investment grade. However, for high yield this leads to a different scenario, as high yield tends to underperform in a falling rate environment, usually coinciding with a weaker economy and rising defaults.

It would have been nothing short of a miracle if monetary policy makers would have been able to set rates exactly right and engineer a soft landing, thus avoiding inflation and maintaining positive economic growth. There are simply too many uncertainties around the lags in monetary policy transmission for this to happen. With inflation materially above target levels, it is likely that central banks will err on the side of caution. This means with hindsight, we can probably conclude that central banks left rates too high for too long, however, given the uncertainty of today, their response makes all the sense in the world. In today’s credit markets the risk of a recession is probably higher than the market discounts for.