Snapshot | January 10, 2023
Corporate Credit Snapshot – January 2023
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Global credit posted mixed returns this month. US and European credit delivered modestly negative returns in December on the back of hawkish commentary from the Federal Reserve (Fed) and European Central Bank (ECB) and potential recession concerns
This month skewed towards a flight to safety as spreads widened and markets effectively closed for the last two weeks of the month
Global recession concerns mounted as investors witnessed the extension of Russia’s mass bomb campaign in Ukraine and questioned China’s ability to refocus on economic growth (rather than on a zero-COVID policy in the face of rising COVID case numbers)
Emerging Markets (EM) delivered positive returns in both high yield and investment grade, driven by the reversal of China’s zero-COVID policy (ZCP) early in December
US credit delivered modestly negative returns in December after a 50 basis point (bps) hike in the Fed Funds Rate mid-month, followed by hawkish commentary from Federal Reserve (Fed) Chairman Powell and potential recession concerns. This month skewed towards a flight to safety as spreads widened after Fed commentary on December 14th and markets effectively closed for the last two weeks of the month. Global recession concerns mounted as investors witnessed the extension of Russia’s mass bomb campaign in Ukraine and questioned China’s ability to refocus on economic growth (rather than on a zero-COVID policy in the face of rising COVID case numbers). As a result, despite Powell’s comments—and before the seasonally quiet period set in—the market had already lowered peak rate expectations and accelerated the timing and depth of rate cuts for the coming year. As we enter 2023, we maintain that well-run, viable business models with reasonable leverage should survive a potential 2023 or 2024 recession. In the meantime, investors can earn a yield-to worst (YTW) of almost 9%, a level only exceeded five times during the most challenging periods of the last 20 years, at prices well below par (Source: ICE Index Platform, ICE BofA US Cash Pay High Yield Constrained Index- JUC0, as of 31st December 2022). We are encouraging our analysts to look for attractively priced survivors at various risk levels to help deliver outperformance in the coming year.
European credit delivered modestly negative returns in December with financial conditions tightening following the European Central Bank’s (ECB’s) hawkish press conference suggesting that the current pace of rate increases will be maintained for longer than expected. This took rates higher across the curve through the month, more than offsetting the positive contribution from tighter spreads over the period. The ECB also downgraded growth expectations for 2023, with recession expected to occur from Q4 2022 to Q1 2023 as a result of the energy crisis and tighter financial conditions. However, ECB policy makers seemed far more concerned with inflation risks, making significant upward revisions in their forecasts for next year. We have been saying for some time that while we believe inflation may have peaked, we believe it will likely remain elevated for longer than many expect, potentially supporting interest rates being held in restrictive territory for an extended period. While this will likely continue to weigh on economies and risk assets globally, we maintain that current yields and spreads suggest good value in credit at this point. We believe the short end of the market is particularly attractive as the rates curve is inverted, with shorter dated interest rates higher than longer dated interest rates. This gives a higher carry in the short end with less duration risk.
Emerging Markets (EM) delivered positive returns in both high yield and investment grade, driven by the reversal of China’s zero-COVID policy (ZCP) early in December. Still, over the next few months, we believe that economic growth may remain subdued in China. We believe China is currently facing two main challenges. First, the progressive but significant changes in the zero-COVID policy (ZCP) should help economic recovery. Real gross domestic product is expected to grow to around 4.5% annualized in 2023 from 2.5% in 2022. However, in the short term, relaxing COVID constraints may come with rising cases numbers, capping consumer confidence and prompting a short sharp fall in economic activity. The second challenge will be the need for further liquidity support while the economy adjusts to the exit of ZCP. Early signals are positive from the government, and we expect further pro-active measures to be announced especially for the property sector early in the New Year. At this point, we believe that whether the glass is half-full or half-empty, the tail risk of a more severe downturn with insufficient support seems to have been removed.
Following a significant sell off in 2022, credit market valuations, compared with historic and forward-looking equity returns, have returned to attractive and competitive levels—notably in euro-denominated bonds. Entering 2023 in an environment of heightened recessionary risks, we advocate a focus on higher quality credits within the BBB and BB ratings segments. We are also constructive on shorter duration strategies, given their resistance to market volatility, access to attractive credit market valuations, and potential for higher yields than have been available in some time. While defaults are likely to increase, we do not believe they will reach previous bear market highs or those implied by the market’s pricing. We remain cautious given the unknowns; however, we also continue to believe that yields for high yield relative to other fixed income assets are priced fairly given the rising pending default outlook. We believe that central banks may be nearing the end of their interest rate hiking cycles, even if their final targets remain unclear. In our view, the Fed may keep rates higher for longer than the market is currently pricing in. We also believe that across fixed income, carry from coupon remains quite favorable.