After a long period of low inflation, interest rates around zero and soaring financial markets, investors are now confronted with issues they haven’t experienced for many years – high inflation that has been much more persistent than expected and, for the most part, hawkish central banks. To make matters worse, this comes against the backdrop of a full-blown war on the edge of Europe and a pandemic that hasn’t completely gone away. The result has been a hugely challenging first half of the year for bonds, with the iBoxx Euro Corporates index down around 12.5% year-to-date as at the end of June.
But what comes next? In Kempen’s Euro Credit team we can envisage three main scenarios from here. We construct these scenarios according to the same framework, based on fundamentals, valuations and technicals, that we use to score the market each month. Let’s run through them in turn before considering how we’re currently positioned.
Scenario 1: muddling through (70% probability)
In our core scenario, inflationary pressures persist, to which central banks continue to react by tightening monetary policy. This results in a slowdown in economic activity but helps cool inflationary forces.
High interest rates cause a relatively brief recession, and unemployment increases but remains low from a historical standpoint. Eventually, inflation falls to a level moderately above central bank targets and markets calm down, leading to buying opportunities for long-term investors. Over the longer run, inflation proves stickier than expected as governments find it hard to rein in spending and wage demands rise against a backdrop of low unemployment. Long-term inflation expectations rise steadily.
What about the prospects for credit investors in this scenario? We believe credit losses would increase initially to slightly above their long-term averages from today’s very low levels, and most of the losses and credit downgrades would be concentrated in a few sectors, such as real estate and industrials. The banking sector should perform relatively well due to its derisked balance sheets and strong solvency levels and the positive impact of higher rates on banks’ earnings capacity.
In this scenario, the iBoxx Euro Corporate index spread would widen further from around 150 bps at the end of June to 165–190 bps. This is a relatively high level in historic terms, but we need to bear in mind that until recently government bonds have generally been providing ultra-low yields: when government bond yields were yielding -0.5%, the extra 100 bps of yield that a basket of corporate bonds provided looked a lot more attractive than when government bond yields are trading at 3% and credit spreads at 125 bps. What’s more, the proportion of BBB issues – the lowest credit rating within investment grade – in the index has risen steadily over time, warranting higher spreads to compensate for the higher credit risk such issuers involve.
Scenario 2: hope (15% probability)
In our optimistic scenario, inflation falls back below the magic 2% level more quickly – within 12–18 months – than rate markets are currently pricing in. This is due to a combination of slowing economic growth, aggressive central bank tightening and easing supply chain pressures. Credit and rate markets rally aggressively whenever supportive data points are published. Fundamentals, valuations and technicals are mostly supportive, and the iBoxx Euro Corporate index’s spread tightens to around 70-75 bps.
Scenario 3: fear (15% probability)
In our final, most pessimistic, scenario, inflationary pressures keep building up and central banks make policy errors that worsen the situation for capital markets. A relatively severe recession ensues, leading to spikes in bankruptcies and credit losses. A high level of uncertainty leads to a liquidity crunch that involves extremely sparse trading of bonds (this has already happened three times in the past 20 years so is by no means unthinkable). Spreads rise to around 250–300 bps, depending on the severity of the liquidity crunch.
In this scenario market participants expect the ECB to stop hiking as soon as the eurozone falls into recession as they believe doing so would be good for the equity and credit markets. But we believe this would be a major policy mistake that would result in inflation remaining high. In such an environment it would take a long time for fundamentals to turn positive again and technicals would remain negative in a liquidity crisis, so spreads would need to be very high to compensate for the risks that investing in credit involved.
How we’re positioned
The significant widening in spreads year to date has to a large extend repriced credit into our mild recessionary scenario. Although we think that it is still a too early to sound the “all clear” sign, recessionary risk is clearly starting to be priced in.
We’re currently positioned for the muddle-through scenario: we’re underweight credit risk, the long end of the credit curve and lower-rated bonds relative to the benchmark. But we’re ready to adapt our allocation as conditions evolve.
Unlike what we have seen in previous credit downturns in the last 15 years where the central banks stepped in with QE to force a sharp and forceful tightening in spreads, the catalyst for tighter spreads in this cycle will most likely have to come from an improvement in fundamentals combined with a less aggressive tightening cycle.
We’ll keep updating our views based on the latest data and adjust our scenarios and probabilities accordingly.
We’ll also be considering other issues that could have a major impact on the credit markets over the coming months. One is the risk of what happens when Japan becomes unwilling or unable to carry on with its yield curve control strategy, through which it has pledged to buy as many Japanese government bonds as it takes to keep 10-year yields below 0.25%. An end to this scheme could spark a liquidity crunch if Japanese investors sell their US dollar and Euro holdings to reinvest in their domestic government bond market.
Another important factor to watch is the widening in spreads in the eurozone periphery. While we are less worried about this than we have been in the past as the periphery has implemented some important fundamental reforms since the last crisis and the banking sectors in these countries are in much better shape, it’s clearly a risk that needs to be monitored as central bank flexibility will be constrained in dealing with the risk of fragmentation in the Eurozone.
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