With economic recovery continuing and strong demand leading to supply-side constraints, the global economy isn’t yet firing on all cylinders.
As Fouad Mehadi, senior investment strategist at NN Investment Partners, explains, this has raised a lot of questions about whether the business cycle has reached peak growth; whether inflationary pressures are transitory, and whether central banks might reduce their accommodative stance prematurely, which could hamper growth and inflation over the medium term.
Mehadi points out that amid these uncertainties, global credit spreads have remained resilient. “Developed market high yields are still backed by strong macroeconomic fundamentals, supportive fiscal policy, and strong commodity markets. The low interest rate environment has helped high yield companies to focus on balance sheet repair.”
However, he questions how much spreads could tighten further from current levels. “All in all, there are some discrepancies between current pricing on global markets and our assessment of the future state of the world.”
As Mehadi explains, the current yield-curve dynamics are not what we would normally expect in the current stage of the business cycle, particularly at a moment when the Fed is poised to scale back its easy monetary policy.
As an example, he points to the recent strong US inflation, growth and labour market releases; followed by declines in longer-dated US Treasury yields. These types of moves – where the yield curve bull flattens – signal anticipation of a growth slowdown.
“We find that the sharp drop in US Treasury yields since June wasn’t only due to lower growth expectations, but also a significant repricing in the inflation component as well. Around 40bps in the cumulative decline in US Treasury yields during the month of July could be equally attributed to downward revisions of the growth and inflation components.”
Mehadi suggests the repricing of growth and inflation appears overdone. “There is ample evidence that recent inflationary pressures are transitory, while growth over the medium term still looks robust. The degree to which market participants are revising inflation lower is greater than the upward revisions we saw earlier in the year”.
He adds:” Given the continued strong demand as economies reopen and the easier fiscal and monetary policies that have been implemented, it seems odd to revise growth and inflation lower down to this extent. The positive level effect of growth – regardless of a somewhat lower growth rate – should still allow the fundamental drivers for US Treasury yields to move higher”.
For now, Mehadi prefers to remain neutral and wait for the appropriate time to initiate an underweight. “The momentum to the downside in US Treasury yields is still too strong. At the same time, there’s a clear asymmetry in favour of higher yields”.
German Bund yields present a somewhat similar picture, although for 10-year Bunds, the growth component has even made a ‘round trip’ this year. This suggests, according to Mehadi, that market participants are completely pricing out recent higher growth, putting implied growth expectations back at levels seen in the beginning of the year.
“This dynamic doesn’t resonate with us. Given the ongoing reopening and still-ample fiscal and monetary policy stimulus, market participants seem to have assigned too much weight to the Covid Delta variant in their future growth assessments”.
He adds: “Based on fundamentals in combination with several statistical and sentiment indicators, we think the recent Bund rally is overdone. We will wait for a stabilization in interest rates and a turn in momentum to initiate a moderate underweight in Bunds”.
High yield credit in a good place?
Fundamentally, the global macro and policy backdrop still looks very supportive for credit. Mehadi says the widening in credit spreads seems relatively small in historical context, though he doesn’t necessarily expect a continuation of the strong credit spread tightening trend we have seen since the height of the pandemic last year.
“Credit spreads in general and high yield in particular are likely to stay close to current levels, perhaps with a slight tightening going into the final quarter of the year”.
He concludes: “But we are keeping in mind that high valuations are peaking and that the default rates are signalling that most of the credit spread tightening is behind us. For now, the risk of a significant widening of spreads is limited in our view, unless a more broad-based risk-off sentiment develops in global financial markets. For now, we prefer to maintain our moderate overweight, mainly for carry purposes”.
Gregoire Pesques, head of credit at Amundi, says that although most of the spread tightening has been done, he continues to see value in credit and mostly in Eur Credit markets (Amundi moved to a more neutral position on US credit last month).
“Fundamentals are good and improving, the ECB will continue its purchase programme and yields will remain low. Given the move, it is time to be more selective and focus on bond selection rather than on beta strategies”.
“In terms of relative value, we prefer subordinated debt, BBB and BB as we expect rising stars to be a key driver of performance. Any significant widening will be an opportunity to add.”