In last month’s Credit Continuum we argued that once some of the short term factors were resolved, credit markets would be able to focus on long term positive trends for 2021.
The anticipated Blue Wave in the US elections did not materialize. Credit markets seem to have settled with a split Congress; a scenario potentially considered the best of both worlds. It eliminates the risk of fiscal exuberance, significant tax hikes, and limits the risk of over-regulation. But it may impact the size and timing of much-needed fiscal stimulus. However, we believe economic news flow in the US is positive, and combined with positive 3Q/4Q earnings trend, strengthens corporate fundamentals.
COVID-19 is raising significant concerns as European governments re-impose mobility restrictions
In contrast, the second wave of COVID-19 is raising significant concerns as European governments re-impose mobility restrictions. The impact of these restrictions on GDP in the Euro zone is yet to be fully assessed.
The recent news on vaccine development provides a boost to long-term fundamentals. Nevertheless, the dissemination and adoption of a vaccine/vaccines on a global scale will take time, and the intermediary period between now and wide-spread immunity can pose some material risks. In our view, as the environment becomes less uncertain credit portfolios should move from short-term tactical positioning to long-term fundamentals based positioning. We are more confident on the positive outlook for credit assets but believe this should be coupled with a strong focus on bottom-up research to identify the vehicles for risk-taking.
Government bonds in this context will continue to see ups and downs, but the long-term risk is that they are titled toward higher yields in our view. The earnings cycle has turned positive globally in 3Q20, and in many regions should stay well oriented in 4Q20 (Europe may be the exception due to lockdowns) in our view. Corporate bond supply has been incredibly high in Corporates have shored up liquidity to shield their balance sheet from the effects of lockdowns.
We expect these fundamentals will play positively in 2021 and limit the default rate to already identified fragile corporates in select sectors. We also expect a restoration of the declining leverage ratio. With continued support from fiscal and monetary policies, albeit flexibly calibrated, we believe credit markets should see further spread compression next year.
High Yield and Emerging Market (EM) credit are potentially set to benefit in this environment.
We believe High Yield provides investors with carry, making it an attractive investment option. As interest rates continue to be low yields will be expected to go up, and High Yield credit should benefit as these companies are more exposed to the economic cycle. EM credit spreads are above those of US High Yield. Emerging economies are set to benefit from the reopening of economies around the world. A Biden administration will also be perceived as more predictable for EM. The US Dollar will likely weaken or stabilize benefitting EM markets.