Why credit can cope with deep uncertainty

With bond markets already in some turmoil over increasingly hawkish central banks and persistently high inflationary pressure, they are also now contending with a major geopolitical crisis and the fallout from a brutal war, writes Patrick Vogel, Global Head of Credit, Schroders.

Where the maelstrom of Russia’s invasion of Ukraine and the West’s response ultimately leads is highly uncertain. We know it is already imposing a terrible human cost. Beyond this there will be many implications for the regional and world political order, which can only become more apparent over time.

As credit investors, our job is to stay level-headed and focus on asset class fundamentals and the companies we invest in. From this perspective we are bound to make decisions on how to position in light of the potential for disruption to markets.

Bonds under stress

For bond markets, the conflict in Ukraine adds to what was already significant pressure. Government yields rose sharply earlier in the year, pricing aggressive interest rate tightening on the back of more “hawkish” central bank rhetoric. European yields have reversed earlier move considerably in recent days, but remain higher than at the start of the year.

Credit markets suffered outflows with spreads widening in recent weeks. This was relatively orderly for the most part, with the market attempting to stabilise on positive earnings announcements, and emerging market bond volatility remaining contained.

But rising yields and spreads have resulted in materially negative year-to-date total returns. Europe in particular was caught off-guard as the European Central Bank (ECB) announced plans to end asset purchases in Q3, “shortly before” raising rates.

With the geopolitical escalation, sentiment veered momentarily toward panic territory, although this had occurred even prior to the actual invasion. Not surprisingly, European credit markets have reacted more strongly than the US to “price in” the risks around the war in Ukraine.

How do we see the macro situation?

Macro level events are very uncertain and are changing quickly. We cannot make predictions on the course of the Ukraine conflict. We are, though, starting to develop a picture of the extent of the risks to the European economy and potential implications for monetary policy.

The risks related to Europe’s reliance on Russian energy is starkly apparent now and evident in European market underperformance. The length of the war and implications for energy prices will be a key determinant for European growth. Here and now, it is a question of how high energy prices go.

There is a pressing need for securing European energy supplies away from Russia. This looks difficult in the short-term, since it is neither easy to import from other countries or to quickly reduce use of fossil fuels, the long-term goal.

Europe is at a disadvantage from an energy price perspective, compared to other parts of the world. The UK does not import much from Russia, while the US economy is pretty self-sufficient. The main implication is increased risk of stagflation for Europe. There are expectations that there will be fiscal help within Europe for consumers and corporates to fend off the energy shock.

In terms of monetary policy, the market’s expectations for rate hikes for 2022 were six in the US and one in Europe. This looked high and has started to moderate. The crisis, economic shock and the deleterious effect on confidence could prompt central banks to temper rate rises. It increases the likelihood of fiscal support. This would likely be targeted toward alleviating the impact of higher energy and food costs for consumers.

Clearly valuations are reflecting low growth and risk of recession within Europe but the length of the war and the nature of fiscal support will be key here. Inflation is also going to rise, so the balancing act facing central banks is even trickier.

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