US and EU will go into recession (China will not)
As the risk of a recession increases, so will dispersion in the markets: here's why. The analysis of Victor Verberk and Sander Bus, co-heads of the credit team at Robeco
In a hike that ends in a recession, rates typically peak earlier than credit spreads. More to the point, rates typically peak around the penultimate Fed hike. We believe we are now crossing the valley between the two peaks. Rates have started to fall and may have peaked in some markets, while inflation appears to be slowing down. Credit spreads have also jumped since mid-October but are set to tighten as markets begin to anticipate a recession that would hurt corporate health.
Gradually the recession gains space and is increasingly integrated into the general outlook, increasing market dispersion. Lower quality credit should experience higher default rates, while the higher end of the market could benefit from lower rates and a rush for quality.
Once the recession has been fully priced in and the spreads' bull cycle is over, it will be wise to take a very long position, even in the high yield space. Typically, the reversal occurs well before default rates peak.
As the supply of European government bonds increases, we expect euro swap spreads to tighten further. Given where we are in the cycle and with swap spreads heavily impacting the total spread of the euro investment grade segment, we look confidently into a moderately long position in euro investment grade markets as we tread very cautiously into other markets poorly moved.
RECESSION IN THE USA AND EUROPE
In 2023, our base case forecasts a recession in both the US and Europe. We expect the recessions to hit these two regions simultaneously, drawing mutual strength from them, but for different underlying causes. The United States is expected to go through a typical cycle of leaps followed by sharp contractions, while Europe will be pushed into recession mainly due to the shock generated by energy supply constraints.
WHAT ABOUT CHINA?
China is in a different phase. It just abandoned its zero-contagion policy. Strange as it may seem, reopening may lead to less economic activity in the short term, as the virus will spread rapidly and consumers will self-impose a reduction in mobility. Within a couple of months, however, the Chinese economy should pick up again.
Will China be able to regain its role as a locomotive and prevent the rest of the world from falling into recession? We doubt it. It is a market in which the fiscal lever does not have sufficient strength and public finances discourage an increase in spending as happened in the past, when the economy needed a boost. In conclusion, we still see no reason to rate fundamentals positively.
HOW THE MARKETS WILL PERFORM
The TINA era (“There Is No Alternative”) is definitively archived. Today, even short-dated Treasuries offer a yield of 4% – a level that only high-yield markets achieved a year ago. The most interesting valuations are found in European investment grade and above all among financial stocks. This market offers above-median spreads and is also cheap compared to its US counterpart.
In developed markets, where the baseline is recessionary, the key question is: what impact will riskier segments of the credit market suffer? At what level are spreads high enough to start buying? We know from the past that spreads typically peak before default rates.
Default rates have only just started to decline, so it seems premature to start aggressively adding exposure to the high yield space. High yield spreads are well below the 1000bp level, where they typically peak in recessionary environments.
With a high yield market currently of higher quality, the default rate will likely end up lower and therefore the market spread will also peak lower.
WHAT THE CENTRAL BANKS WILL DO
While the rate squeeze may be nearing its end, the quantitative tightening cycle has only just begun. The Fed, the ECB and the BoE have started to shrink their balance sheets. With this demand fading and now reversing course, there is an urgent need for new buyers for credit products. Helping is the defensive positioning, which seems common among bond investors, and the high liquidity found in many investment portfolios.
Technically speaking, then, central banks still drive the markets. As long as central banks continue to withdraw liquidity from our market, the only indication we can follow is that of caution.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/recessione-usa-ue-cina/ on Sat, 01 Apr 2023 05:07:54 +0000.