One key rationale behind our view on lower growth and lower inflation ahead is the extraordinary amount of tightening that global economies have seen in the last 15 months. US money supply growth is seeing the fastest contraction since the 1930s (the picture is similar in Europe and the UK).
Monetary policy acts with ‘long and variable lags’. The bulk of the US rate rises happened only in H2 2022, so haven’t hit the economy yet. We expect an easing cycle to begin, led perhaps by emerging market central banks, with the Federal Reserve cutting rates around the turn of the year.
The historical relationship between tightening in lending standards and increases in unemployment is clear:
Credit markets, led by the high yield market, have continued to perform pretty well, and are not pricing the slowdown we foresee. We have been gradually reducing our credit exposure and are likely to continue to do so in the coming months.
In the meantime, focus remains on defensive sectors, secured structures and preference for bonds with short maturity or close call date.
Now that the debt ceiling has been lifted, the replenishment of the US Treasury General Account will imply a meaningful increase in the issuance of T-bills and Treasuries. That will extract a meaningful amount of liquidity from the financial system, at a time when the Fed is already undertaking up to $95bn per month of quantitative tightening.
The outlook for credit is more nuanced as the global economy slows down: default rates are likely to rise and some companies will find that their capital structure is no longer tenable with higher borrowing costs. However, the data shows that at these levels, high yield has historically delivered a positive return over 12 months most of the time, and delivers double-digit performance over half the time. If investors can avoid the losers, there are exciting opportunities in the market and we remain invested, but with caution.
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