Snapshot  |  March 8, 2023

Corporate Credit Snapshot – March 2023

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• Global credit weakened this month, driven by rising rates as both the Federal Reserve (Fed) and the European Central Bank (ECB) hiked interest rates again.
• Excess returns were more mixed with spreads tightening in US high yield (HY), EU HY and Emerging Markets (EM) investment grade (IG), and with spreads widening in US IG, EU IG and EM HY.
• Despite the market’s initial dovish reaction to those central bank meetings, communication since then has confirmed the “higher-for-longer” narrative and the market now seems to expect at least three additional 25 basis point (bps) rate hikes from the Fed through June.
• In Emerging Markets (EM), the earthquake in Turkey this month has led to a tragic loss of life and has significant economic implications; we expect economic growth to be impacted and for the budget deficit to rise given the fiscal support needed.  In China, we believe data regarding consumption, passenger traffic, freight flow, and international flights all point to recovery, perhaps as early as this quarter.

US

US high yield (HY) posted negative returns in February, driven entirely by rising rates as the Federal Reserve (Fed) hiked interest rates again.  Despite the market’s initial dovish reaction to the Fed’s meeting, communication since then has confirmed the “higher-for-longer” narrative and the market now seems to expect at least three additional 25 basis point (bps) rate hikes through June. Higher than expected inflation numbers have continued to support that message, as has better-than-expected economic data, which points to a more resilient global economy.  HY spreads tightened in February against a backdrop of resurgent rates, resulting in overall higher yields. Earnings season is mostly behind the market at this point, and we have seen a slowdown from the torrid post-COVID recovery period.  In our view, credit improvement likely peaked during Q3 2022, but overall credits metrics still remain near 10-year best levels, indicating that HY credit is still in strong, resilient shape.  We continue to believe that today’s high yields provide a reasonable cushion around expectations for the economy and rates over a 12-month time horizon.  We maintain that short duration paper remains in a historically interesting position with a dollar price below par in a strong economy where we expect pull-to-par scenarios to accelerate through the year.  In our view, short duration HY credit is poised to deliver strong risk adjusted returns as markets gyrate around economic expectations.

EUROPE

February was a weak month for European markets.  Interest rates rose as both the Federal Reserve (Fed) and the European Central Bank (ECB) hiked interest rates again. Despite the market’s initial dovish reading of those central bank meetings, communication since then has confirmed the “higher-for-longer” narrative being pushed by both the Fed and ECB. Higher than expected inflation numbers have continued to support that message, as has better-than-expected economic data, which points to a more resilient global economy.  Indeed, we saw the month-end reports from the first European countries showing February inflation numbers coming in ahead of expectations. While rates drove this month’s performance, European investment grade (IG) spreads were relatively resilient.

EM

Emerging Markets (EM) had a weak month, driven by rising rates as the Federal Reserve (Fed) hiked interest rates again.  The rates rally that we saw in January—inspired by the prospect of falling inflation and a 2023 Fed pivot—has been put behind us in February due to the persistence of sticky inflation and better-than-expected economic data.  The earthquake in Turkey this month has led to a tragic loss of life and has significant economic implications; we expect economic growth to be impacted and for the budget deficit to rise given the fiscal support needed.  In China, we believe data regarding consumption, passenger traffic, freight flow, and international flights all point to recovery, perhaps as early as this quarter.  A better-than-expected January credit report provided a further indication that the rebound is underway.  We note that burgeoning bank loan growth in China this month likely benefitted from increased credit support for real estate developers, although household loans remained soft—consistent with the near-term weakness in housing activity.  Brazil’s central bank combined an unchanged stance on rates with an unexpected hawkish statement, signalling a willingness to keep rates high to cap rising inflation expectations.

OUTLOOK

For now, we remain in a ‘good news is bad news’ market. Good news emboldens the hawks, supporting fears of higher rates and tighter financial conditions. While we believe yields and dollar price discounts remain attractive, spread levels are mixed around 10-year averages as markets forecast continued economic expansion with less credit stress.  Given the prospect for continued restrictive central bank policy in the US and Europe as the inflation fight continues, we expect 2023 to bring more dispersion across credit as idiosyncratic credit risk increases.  We favor idiosyncratic themes in high yield (HY) as we expect defaults to increase over the next 12 months, although most defaults are already recognized in market prices and thus will have minimal impact on performance.  Importantly, we expect the overall credit cycle default peak to remain well below prior cycle peaks given the current strength of many balance sheet fundamentals and the market’s benign maturity profiles.  We expect this relatively mild default cycle to be supportive of credit spreads and we expect to see HY opportunities emerge on spread widening.  We continue to believe that the lack of a strong consensus around interest rates and future recessionary risks will cause the market to swing both ways through 2023, driving intermittent periods of strength and weakness. With yields close to multi-year highs, we believe dips could present opportunities for investors who see value in credit, but perhaps weren’t positioned for the rally at the start of the year.