Credit Outlook: widespread chaos after generosity

We have seen a marked appreciation in fixed income, but panic and environmental volatility can also offer opportunities.

This year, US Treasuries had the worst first quarter (January to April) since 1788. In addition, credit spreads widened. We have seen a marked appreciation, all criteria combined, of bonds. Prospects seem to be darkening and it would be easy to sink into pessimism. But prevailing panic and volatility can also provide opportunities.

We are already seeing some market segments starting to look interesting. Investment grade bonds look cheap at current levels, and investors who are able to manage volatility and willing to take a longer investment horizon may start buying. As far as High Yield bonds are concerned, we still have to wait, although quality stocks in this segment are already attractive in our view.

How did the world get into such chaos? “The political response to the Covid-19 pandemic seemed to be an excellent remedy during the health crisis, but now it appears that the combination of massive fiscal and monetary stimuli has constituted an excess of generosity, which is one of the main hotbeds of the great evil called inflation”explains Sander Bus, co-head of Robeco’s Credit team.

The perspective darkens

As prices continue to rise in many sectors of the economy, leading indicators increasingly point to the risk of recession. Current levels of consumer confidence, producer confidence and affordability of housing, as well as the reversal of yield curves, are all indicators of difficulties. This should not surprise us when we consider the brutality of monetary tightening currently underway in response to runaway inflation.

Central banks today have no choice but to further tighten financial conditions to slow their economies and restore the balance between supply and demand. And they will only stop this tightening if the facts clearly show that inflation is falling. Inflationary pressures are highly unlikely to disappear on their own.

Yet this is what politicians were hoping for when they still used the word “transitory” in 2021. But this word has long since been abandoned. “If we are to believe in economic history since 1955, we are bound to conclude, as Larry Summers and Alex Domash were the first to postulate, that with the current levels of inflation and overheating in the labor market, the tightening of the Fed has always led to a recession “says Jamie Stuttard, Robeco’s credit strategist

Inflation hits new highs

Inflation is at new highs in the US and Europe, but remains somewhat more subdued in China. In the US it is clear that the main trigger was an excess of fiscal stimulus at a time when the output gap no longer existed. In Europe, excessive budget spending also played a role, but there was also a food and energy crisis due to the war in Ukraine, as well as imported inflation due to the currency effect.

Inflation caused a real income shock that the United States had not experienced since the 1970s. This shock, combined with the sharp tightening of financial conditions, coupled with the fragility of the Chinese macroeconomic context, constitutes a real risk of recession. The current situation bears further similarities to the inflationary episode of the 1970s. At the time, politicians also declared inflation transient as it was initially triggered by external shocks.

However, even though these were temporary shocks, they led individuals to expect higher inflation, which added to the inflationary dynamics and contributed to a spiral of rising prices and wages that developed. No out-of-control inflationary spiral has started yet, but it is a scenario that central banks absolutely want to avoid, because this type of inflation can be very difficult to fight.

Healthy companies, but beware of debt levels Corporate profit margins are at cyclical highs, which is not uncommon on the eve of an economic slowdown. Businesses benefited from strong pricing power in 2020 and 2021, and supply constraints combined with government support measures helped boost margins. Profits are between 20% and 40% above 2019 levels in all key regions.

An important element in judging the health of companies is their sensitivity to interest rates. Obviously, companies that have a high level of debt and a large volume of variable rate debt on their balance sheets are more vulnerable.

In Europe, the situation is even more difficult due to the gas shortage and the evolution of trade, which has catapulted gas and electricity prices in euros to very high levels. The energy crisis is penalizing for Europe but, at the same time, it will prevent the ECB from raising rates with the same brutality as the Fed.

Given that European banks are overweight in our portfolio and that many clients still have the global financial crisis in mind, we feel it is worth making some comments on this segment. During the pandemic, a significant share of SME credit risk was transferred from bank balance sheets to public entities through state-guaranteed loans. This instrument was mainly used in southern Europe, such as Italy, where today more than 10% of GDP is made up of loans guaranteed by the state.

This means that, in times of escalating insolvencies, banks are partly protected, because part of the losses are borne by the state. “We conclude that these healthy equity positions and the likelihood of lower credit losses than in previous episodes of economic stress should help banks weather the storm unscathed,” said Victor Verberk, co-head of the Robeco Credit team. We are convinced that banks will not be the epicenter of the crisis during the next recession. “

Valuations are becoming more attractive

In all segments of the credit market, spreads are now indisputably above median spreads. They even reached the top quartile in the euro investment grade and high yield credit market.

In the investment grade segment, we have reached levels where we are confident with portfolio betas just above 1. For high yield and emerging debt portfolios, we have also reduced our underweight to beta, but have not yet returned to positive territory. for all portfolios.

We are approaching the High Yield segment with more reserves than the investment grade segment. The relationship between high yield bond spreads and investment grade bond spreads is tight by historical standards, increasing the possibility of underperforming high yield bonds based on risk. “We believe lower-rated stocks are particularly vulnerable,” explains Sander Bus. A recession will increase idiosyncratic risk and dispersion in this segment. Not rated enough yet. “

The technical factors are not easy

The main driver of asset prices this year is clearly central bank policy. There is considerable uncertainty about the extent of monetary tightening required to restore price stability and bring inflation rates back within target, without triggering deflation. This uncertainty generates great volatility in the bond markets.

During this year’s correction we experienced days that reminded us of March 2020 and September 2008, with very unfavorable liquidity conditions. This situation also reminds us that investment bank balance sheets are no longer the same as they were before the global financial crisis. Due to more regulation, tighter risk management and a lower propensity to physical inventory, investment banks are no longer able to play the role of shock absorbers.

That is why we are witnessing the rapid deterioration of liquidity in the markets where everyone is running. “This once again underlines the importance of being contrarian in these markets,” says Victor Verberk.

You can be fooled by strong rallies in bear markets and try to take risks when most people throw in the towel and vice versa. Market liquidity is very fragile and you have to use it to your advantage. “


Overall, valuations indicate a little more optimism in credit markets, but at the same time fundamentals and technical data remain fragile. During the period of quantitative easing, we learned not to oppose the Fed, and the same is true today, in a period of tightening. The Fed has declared war on inflation and market weakness is collateral damage it accepts. Spreads could very well widen further, in which case we will consider a further increase in beta.

“The risk of recession has increased and the market has also shifted towards this scenario, notes Sander Bus. However, we have not yet entered the phase of capitulation and the unwarranted search for low ratings. These opportunities could very well present themselves in the next three or six months. “

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