The snow globe economy will settle, but not quite yet

Financial markets have been struggling to deal with two headwinds inflation and the war in Ukraine. The Russia Ukraine war has exacerbated the inflation outlook while also being perceived as worsening global supply chain disruptions. This has caught central banks off guard as they now scramble to attempt to get "ahead of the curve". This means ending quantitative easing (and starting quantitative tightening in the case of the US) and ramping short term interest rates as high and as fast as economies will allow.

Considering the scale and unexpected speed of these two headwinds it is somewhat surprising that risk markets fared as well as they did in in the first quarter. As the new quarter begins, we remain cautious With central banks on a quest for higher rates and yields, fixed income will remain under pressure and it will continue to be a tough environment for investment grade.

Central banks are leading us to believe that rates can rise (and quite far) as economic growth will remain robust, but only a few months ago they were calling inflation "transitory". With credit spreads having recovered two thirds of their widening since the lows of mid March, we feel that markets are erring once again towards over optimism.

On a positive note, credit market technicals have been quite strong. Investors appeared to be well hedged at the start of the year with relatively high cash balances Outflows have mainly affected investment grade, continuing a trend that we witnessed throughout H 2 2021. As a result, there has been a noticeable compression in spreads as high yield outperformed investment grade We expect this trend to continue as rates sell off and while confidence remains that economic growth will not be unduly hampered. Were this to change, we would expect markets to start pricing in greater forward default risk and as a consequence credit spreads would widen, with weaker high yield names leading the charge.

Overall, we stick by our view that 2022 will be characterised by increasing spread dispersion and rising volatility during the first half of the year, followed by a more benign environment in the second half as credit markets price in the bulk of the interest rate rises as well as any added risk premia to take into account rising default risk associated with slowing economic growth.