From disinflation to reflation to stagflation?

‘Discrete’ financial markets do not operate in a vacuum; they are inexorably linked. The March period of Q1 shows volatility in certain pockets of credit markets, particularly those that are most sensitive to interest rate moves. Other pockets appear calmer.

On a total return basis, UK sterling credit was among the worst performing asset classes as of late-March. If we distil this underperformance into total returns versus excess returns – the returns associated with changes in credit risk premia – we can see that the vast majority of this performance is rates-driven. For example, of the -3.3% monthly return as of March 19, 17 basis points (bps) came from the credit risk component. The rest can be attributed to the rate move.

Returns in US high yield (HY) are largely driven by rates too, with 30bps of the -1.2% performance as of March 19 coming from credit risk. Global rates moves are also affecting returns in investment grade (IG) markets. Of the -1.8% return in this segment, only 13 basis points has been driven by changes in credit spread. The one outlier in this analysis is European credit, where spread moves explain a large part of the change in total return in the month-to-date period. 

On the face of it, year-to-date performance shows some fairly benign moves. For example, looking at US high yield versus European high yield, we see similar total returns. In the year-to-date period until the attack on Iran, non-US credit had been outperforming US credit. Since the attack on Iran, this dynamic has flipped.

In the case of sterling credit, we can see that the move is largely driven by rates. However, for European credit and emerging market (EM) credit, it’s not all about rates for the more spread-sensitive markets. European high yield and lower quality EM credit underperformance can also be explained by spread-widening.

We think this is the result of a number of factors. First, it could be down to a reversal in credit markets that had rallied for several months as part of a ‘hedge the US’ rotation trade. Perhaps more concerning, this could also reflect a change in expectations for the macro environment. Whereas the US is a net exporter of energy, Europe imports about 60% of its energy needs from abroad, with oil comprising 70% of that. The combination of the supply-shock-driven spike in inflation and an increase in interest rates raises the specter of stagflation in Europe. As such, it would make sense to see a sell-off in markets that had performed so well in the previous context of clear macro visibility.

We suspect that the specter of stagflation exists in the UK as well. It’s hard to see how a prolonged increase in borrowing costs and fuel prices would not put some degree of pressure on consumers and corporates.

Contained credit spreads on the sidelines

If the conflict continues, we will likely see extended pressure on the global economy. The longer the effects of this supply shock last, the greater the potential for realized demand destruction. That is a credit negative. 

While this remains a concern, we do need to place the current geopolitical risks and supply shock in the context of the current macroeconomics and valuations. Spread moves have been relatively contained against a backdrop of almost historical tights. As such, we’d have to see some spread widening given the rupture to a supportive narrative for credit. This has been despite the risk of the Iran conflict affecting a wide circle outside the region economically, and potentially militarily.

We attribute this relatively contained reaction to three potential factors:

• First, macroeconomic conditions and solid corporate fundamentals were supportive of credit markets ahead of the attack.
• Second, there is less leverage in the financial ecosystem than there was ahead of the 2008–09 global financial crisis (GFC), largely due to enhanced regulatory supervision.
• Third, the banking system is in decent condition, even as rating agency Moody’s reports that US banks have exposure of approximately US$300bn to providers of private credit—just under 3% of their loan book.

The extent to which the US and Israel continue their military excursion into Iran remains to be seen. With one eye on the US mid-term elections in November, and the other on public opinion, US President Donald Trump may seek to de-escalate the conflict sooner rather than later. That being said, the price of crude is not entirely under Washington’s control, and we could very likely be in a ‘higher for longer’ oil price scenario.