2023-07-11 17:59:36
Julien Houdain and Martin Coucke (Schroders) | The volatile start to the year for credit markets has calmed down somewhat in recent months and it appears that the major economies have managed to avoid a deep recession. However, with Europe still adjusting to the latest interest rate hikes from the European Central Bank (ECB), high inflation and low growth remain a struggle within and outside the region.
In this context, it seems that volatility could pick up in the second part of the year. Below, we discuss how investors can position themselves in credit and where they can find sources of stable income generation to protect themselves from both inflation and price depreciation.
Outlook for the remainder of the year and some advice for navigating in the current environment
We expect the economy to continue to slow down. It seems that the recession in developed markets that was expected in the first part of the year has been delayed, probably until the second half. Optimism around the Chinese reopening is also fading as the latest figures show weaker than expected growth.
However, we hope that the recession is quite shallow. In fact, there are positive signs: the monthly rate of inflation, for example, has already slowed down quite a bit due to the quantitative tightening measures taken by central banks, and this is likely to continue. There may be a few more hikes on the horizon, but overall it looks like central banks are beginning to relaxat least for now.
The current environment is difficult to navigate, so careful stock selection remains critical to performance. Credit investors should also keep an eye on the amount of risk that they assume and the duration of your portfolio to take into account the economic slowdown and better cushion the current rate environment.
Inflation and how it affects credit
It seems that the tide is beginning to turn. The market seems to agree, as it anticipates a significant decline in inflation in the next 6 to 12 monthss. Thus, terminal rates are probably close to their maximum, at least in the United States. It may take a bit longer in Europe, but even here we should be close to terminal rates. UK should follow soon after. However, despite the turnaround in inflation, it can be expected that we continue to operate in an environment of inflation and high interest rates longer, which will also keep volatility at high levels. Events such as the British gilt crisis and, more recently, the turmoil in the US banking sector are good examples of how things can change very quickly in today’s environment. Agility is an important trait, as investors need to be able to react quickly and effectively to any market turbulence.
From a strategic point of view, the current environment can be unforgiving to companies, and in the coming months we expect to see a increase in defaults. This is also already reflected in the ratings.
The key is flexibility
Active bond selection is crucial as it helps investors avoid the pitfalls of volatile markets. You have to focus on choosing the right names and avoid surprises. There are currently several scenarios for how things could play out going forward, so investors should be vigilant. If the economy takes its time to slow down, inflation could pick up again. This would force central banks to further raise interest rates. Until now, the economy has remained surprisingly strong, excluding some cracks in the banking sector, so that’s definitely something to watch. That’s why it’s important be flexible and be able to change your mind based on what we observe in the market and what the most recent data tells us.
Banking sector: prospects after bankruptcies in the US
It is important separate the US and European banking sectors. US banks operate in a world apart and the market is highly fragmented. Smaller US banks are also much more exposed to commercial real estate than their European counterparts, which means that we are not seeing the same amount of deposit outflows in Europe as in the United States. Ultimately, it was above all a lack of regulation that caused the American banking crisis. The Credit Suisse bankruptcy was more the result of years of mismanagement than a more systematic problem in the European banking industry itself.
So that, the current turmoil is centered much more in the United States and we remain cautious. However, the US banking sector should be able to weather the storm quite well. The market has already widened a lot in terms of credit spreads, although nothing has happened. There are actually a lot of exciting opportunities right now if you know where to look.
Investment opportunities by sectors
Given that we believe the economy will continue to slow and we are likely to see more defaults in the future, investment grade companies are a way to go. Companies with BBB ratings and good fundamentals currently offer decent premiums.
Regarding the different themes, defensive companies that provide stable income despite market volatility should do better in this environment than their more cyclical counterparts. The focus should be on companies with resilient and sustainable businesses with a good capacity to generate cash flows that make it possible to face potentially higher financing costs. The real estate sector is the one that stands out the most today and is probably the one that offers the greatest opportunity alpha generation as spreads approach record levels. Despite the headwind from rising interest rates, there has been no significant deterioration in fundamentals, as rent indexing to inflation has offset the negative impact of higher yields. The European logistics sector seems particularly interesting, as it is still likely to benefit from increased eCommerce adoption. In this sense, Europe still has to catch up with more advanced countries such as the United Kingdom or the United States.
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