Jeff Boswell, Head of Alternative Credit at Ninety One and Portfolio Manager of the Global Total Return Credit strategy discusses the shifting backdrop across credit markets and why strong credit selection will be key.
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.
What are the key risk factors for credit markets in 2022?
Potential new COVID variants
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.
Risks from central bank policy
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.