02 February 2022
Over the past year in global credit markets, we’ve seen the phenomenon of a rising tide lifting all boats, with spreads and yields approaching historically tight levels across almost the entire credit spectrum. In our opinion, that backdrop has now started to shift. A combination of stubbornly persistent inflationary pressures, supply-chain issues, labour market concerns, and the paring back of support from central banks, all have the potential to meaningfully influence the performance of individual credit markets in the year ahead. Against this backdrop, we believe investors should be minded to opt for an unconstrained, nimble strategy providing diversification across a broad opportunity set, whilst employing a highly selective approach in the individual credit selection.
Although highly contagious, thankfully the symptom severity of the Omicron variant of COVID-19 appears to be lower than initially feared, and the UK sees its restrictions reduced this week. Nevertheless, pandemic-driven economic disruption will continue to lurk and even with some normalisation - increased immunity and pharmaceutical developments - we can expect further flare ups, and with that the potential for knee-jerk market reactions. Notwithstanding the fact that a more detrimental future virus mutation would result in more significant economic disruption.
In short, investors should expect continued virus-related headlines, and any investment in virus-affected credits should be priced appropriately for the potential resultant risk and volatility, with investors looking to take advantage of attractive entry levels where possible.
We believe central bank actions in the coming year represent the biggest risk to markets. If central bankers are forced to chase inflation with more monetary policy tightening than economies can withstand, market reactions could range from local bouts of volatility to more dramatic conditions. Although a monetary policy error is not inevitable, it is currently hard to judge whether one is likely to materialise or has happened already.
The US Federal Reserve has chosen to pivot to a hawkish stance, despite the Omicron-driven slowdowns, reflecting the persistence of high inflation figures and the tenacity of underlying supply-chain and labour-availability conditions. The Fed has embarked on a faster paced asset purchase taper programme and has forecasted more rapid interest rate rises over 2022-23. While the European Central Bank is forecasting a more dovish path in 2022, there is a broadly coordinated path of tightening globally, with rates markets pricing in a significant number of 2022 hikes in Canada, the UK, and Australia. This equates to a meaningful tightening of liquidity, the impact of which might prove detrimental to macro conditions, and/or risk appetite.
Given central bank liquidity has been a key technical tailwind driving credit markets over the last 18 months, with central banks slowly but purposefully removing the punch bowl, the potential threat of increased volatility and credit market performance divergence is very real. In this environment credit selection is likely to be increasingly important – avoiding unnecessary and under-priced idiosyncratic credit risk, and staying disciplined in portfolio construction, avoiding the most vulnerable areas of the market.
The impact of broken and strained supply chains remains a key risk to the economic outlook. The failure of once-reliable supply chains – that took decades to construct – to self-correct could result in a breakdown of manufacturing cost structures as businesses invest to rebuild more reliable supply chains. The longer this triaging process takes to play out, the more extended ongoing price pressures and volume-related revenue declines across multiple sectors could be.
Labour shortage is another major source of uncertainty for the outlook, which will likely have the longest residual impact on inflation figures and, ultimately, central bank actions. Worker availability is at acute levels, exacerbated by demographics and immigration policies, as a decline in working age continues amongst an ageing population. Anti-immigration politics have been big issues in the US and UK for years. Assuming this doesn’t change meaningfully, the most likely solution to the labour shortage is higher wages, which could in turn impact inflation and result in central bank reaction.
The key related risk for credit investors is the impact on individual companies – with some business undoubtedly more exposed than others. In this vein, individual credit selection will be key in attempting to avoid the most exposed corporates.
Rising tensions are bubbling up to the surface on several large-scale geopolitical fronts, any one of which could have a very damaging impact on economies and markets if mismanaged - whether that be between Russia and Ukraine, the US and China, China and Taiwan, or even through the pivot in internal Chinese economic policy. Properly quantifying such risks is exceptionally difficult and we believe bottom-up selectivity remains key to avoiding credit exposure at the epicentre of these geopolitical flare ups.
While the recent volatility has seen a modest repricing in certain credit markets, we believe the uncertain outlook will require strong investment discipline and active use of the full opportunity set in order to maximize returns. We believe attractive carry is still on offer, but now is the time to be particularly discerning when investing in any credits particularly exposed to the above risk factors. Whilst ever evolving depending on market conditions and individual opportunities, our positioning has generally been to increase floating rate and short duration exposure, taking advantage of relatively flat credit curves and attractive carry in those parts of the market. We have also been reducing traditional call constrained high yield and rotating into more defensive carry implements such as CLO’s and short duration bank capital.
While 2020 and 2021 was about dynamically allocating across global credit markets to best capture the rally, we believe the focus in 2022 will be about strong credit selection and shrewd portfolio construction. While attractive pockets of opportunity still exist within credit markets, we believe that as some of the above risk factors play out, there will be good opportunity for the dynamic credit investor with a broad opportunity set to take advantage of the resultant volatility.