Market exuberance continued in December and through the first days of January, as risky assets posted a strong performance, once again on the back of signs of weakening inflation and the hope that central banks would strike a less hawkish tone. European assets outperformed their American counterparts, while Emerging hard currencies led the way in terms of performance alongside USD credit. Euro zone sovereigns also delivered strong returns across the board, with peripherals generally outperforming core rates.
It is important to note that it is not a shift in fundamentals or paradigm that appears to be causing this strong rally. Instead, the risk-on environment continues to be driven by expectations of a pause from central banks on the back of lower inflation prints, principally pressured by declining commodity prices. There also appears to be a perception that though the strong rate hikes have had some impact on growth (leading to lower inflation prints), the slowdown is not pronounced and G4 economies are still exhibiting strong resilience.
On the credit front, fundamentals also appeared to hold up well in a relatively quiet month. The rally on the credit market was led by the sectors (real estate, utilities) that suffered the most over the course of 2022. Higher rated issuers also performed well, with EUR BBB-rated issuers narrowly outperforming B-rated issuers.
The case for US rates is evenly balanced
Though growth momentum is slower in the US, the probability of a full-blown recession appears to be increasingly weak. The business cycle is experiencing a downturn, though it is expected to pick up again shortly. A strong labour market is giving the Fed cause for concern, particularly since non-farm payroll prints have been extremely encouraging. Hence, expectations point towards two additional hikes from the Fed, though there does appear to be some market resistance to this.
Most indicators are now pointing towards a decline in inflation, as CPI prints have moved marginally lower. The wage inflation cycle has now joined consumer and housing inflation in their downturn, and there is a strong probability of inflation moving into the “cooling” phase. With Covid distortions now normalising and the Chinese reopening potentially reducing the supply/demand imbalance, there is a strong possibility that inflation will continue to taper, putting downward pressure on US rates.
Eurozone still vulnerable to rate hikes
While growth is quite meek in Europe across the various countries on the continent, inflation still remains at peak levels. This indicates that the central bank still has more work to do. The business cycle doesn’t appear to have the same momentum as in the US, and though a severe downturn is not expected, there are doubts about whether a material improvement will be witnessed over the next six months. The ECB continues to lag behind other developed market central banks in terms of the rate hiking cycle, implying that there could be more tightening to come this year. This was highlighted in the latest speech given by Christine Lagarde (head of the ECB), with hawkish guidance on future rate hikes. The ECB announced that it will start quantitative tightening (QT) related to the APP at the beginning of March 2023, with a "measured and predictable pace”, leading to a shrinking of its balance sheet by €15 billion per month on average until the end of Q2 2023. In terms of supply and demand, it is interesting to note that the outlook is not particularly supportive for sovereigns, as deficits are adding pressure on issuance in addition to Quantitative Tightening, and could lead to an increasingly steeper EMU curve. That said, we see clear Relative Value opportunities between EMU issuers, driven by idiosyncratic factors beyond core vs. non-core. We continue to hold a conviction for Austria in particular, whose spreads continue to appear excessive in light of fundamentals. Peripheral sovereigns will be penalised by the ECB’s recalibration of its monetary policy despite increased European solidarity. Supply dynamics will deteriorate in 2023. Positioning is, however, turning more supportive, following a continued decrease in long positioning on non-core.
Dispersion in some of the G10 rates
In a rising rate environment, Canadian rates appear vulnerable. Inflation has surprised to the upside, and employment figures remain extremely strong, even more so than in the US. Rates appear to be on the expensive side, as we remain near lows in terms of spreads and the carry is weak. Positioning remains long, as investors seem to be wary of an early pivot. New Zealand rates on the other hand remain relatively attractive on the back of some deterioration in macro-economic data and growth is likely to see more declines. In Japan, following a hawkish tone from the central bank (one of the last to give in), it almost seems evident that yields are unlikely to experience any move downward in the near term.
Dollar strength could be challenged
After a very strong 2022, the strength of the USD appears to have peaked and over the past month, it has underperformed almost all other currencies. With inflation in the US moving lower, the Fed is not as hawkish as in the past, depriving the greenback of a vital source of support. Though we do not expect significant weakness in the USD, particularly since its remains a safe haven currency in a relatively volatile period, there are certain EM FX that could outperform the dollar. While overall market positioning is still long on the greenback, clearly, certain carry trades vs Latam/Asia currencies offer attractive entry points. Furthermore, risk sentiment is positive on currencies like the Mexican peso and Brazilian real, especially with China reopening.
Opportunistic stance on Emerging Markets
Eastern European markets are still outperforming, and remain supported by the strong European fiscal programme. Czech yields have moved downwards, but still remain a good carry trade. They have not moved as much as their CEE peers and with a stable currency and the theme of slowing inflation holding there as well, we still see value in that market. In LATAM, Brazilian rates are offering very attractive real yields, as nominal yields of 13% are clearly in excess of inflation. China’s reopening in particular should be supportive of the Brazilian economy, albeit we still likely won’t see commodity prices rising back to the extreme highs registered some months ago.
Higher conviction in investment grade, lower caution on high yield
The context has seen plenty of good news for credit. Lower inflation levels, more resilient than expected fundamentals, lower probability of full-blown recessions, less hawkish central banks and the reopening of China have combined to deliver an almost goldilocks scenario. Market technicals also appear supportive and reinforce the case for investment grade credit. Yield levels are still high, even after the recent spread tightening (20 bps in the EU). Amidst this rather strong view, we feel it is necessary to still keep in mind some risks as company guidance still remains relatively weak (or at times non-existent) and spreads in certain segments are clearly at very tight levels. Bottom-up selection is therefore still critical in this overall positive context.
A neutral stance on high yield (compared to the previous negative stance) is warranted. Technicals continue to be supportive, as we do not expect much supply. Rising stars are still expected, but are unlikely to outstrip fallen angels. Due to improving quality on EU HY (that is now 70% BB), even after the strong December rally, there are some good short-term prospects thanks to the carry component. Though default rates are still below historical averages, expectations are rising, and dispersion is likely to increase, once again warranting a selective approach.