Credit Market Daily #48

4th-Nov-2022

Good Afternoon –

“There is no easy outcome to this” was one of Bailey’s comments in the BoE presser yesterday.

Credit wise the BoE statement points to potentially lower yields than currently baked-in and wider credit spreads.

Given the length of the recession (6 quarters expected, although the BoE suggested this was highly sensitive to external factors); the consumer is subject to both tighter monetary and fiscal policy and inflation is expected to remain high for at least 6 months – staying defensive seems sensible.

This means IG over HighYield, sector Non-Cyclicals vs. Cyclicals, those that benefit from a weak GBP and generally shorter duration.

If the BoE are right and markets are pricing UK rates too high then a recalibration of yields lower should be initially positive for GBP credit.

I say initially as credit spreads should widen further – we have yet to see real recessionary pain in the UK corporate space.

On the face of the BoE’s statement, there is little to cheer about – you will see higher rates, you will experience higher inflation (lower spending power), you will pay more for energy and you will experience a 6-quarter recession through H1 2024, which will raise unemployment

But the BoE led us gently into the night. There was hardly any reaction in rates and credit and UK equities outperformed yesterday

The blow was softened by their thinking that current market rates are pricing in a too high terminal rate.

They even felt the need to take us through their assumptions, which point to lower rates, with the caveat the risks were to the upside w.r.t. inflation and so further large hikes, however unlikely, could not be ruled out.

Regardless of the projected path of the bank rate, the MPC judges that the risk to its inflation projections are skewed to the upside. In part, the skew reflects the possibility of more persistence in wage and price setting. The upside skew has important implications for monetary policy . Just to put it simply, yes, we expect a steep fall inflation, but there are substantial upside risks to that path.

Andrew Bailey, BoE, 3rd-Nov

It was a Goldilocks of a presser that gives the BoE plenty of room to manoeuvre should they need to. And this is before the Autumn statement.

The meat of the discussion was around this slide:

Essentially – using the 5.25% market rate assumption for terminal rates means a deeper recession with the BoE seeing inflation at 1.4% at the end of 2023 and 0% end of 2024. Well off its 2% target.

However, using the current rate of 3% any recession is shallower and inflation would be “a little over” target at the end of 2024.

Bailey was quick to point out that the BoE was not telling the market that 3% was the magic number, rather the rate needed would lie closer to the 3% rate than the market-implied rate.

The main takeaways were

• A market-priced terminal rate of 5.25% peaking in Q2
• Inflation is to peak at around 11% in Q4 and start declining in early ’23 as energy prices annualise
• Their analysis does not include any Fiscal changes to be announced in the Autumn Statement
• Energy cap-reduce inflation and supports spending. Gas prices are expected to move higher
• Does not take into account the autumn statement 17-Nov
• Some Signs of the labour market softening but it remains tight, number of unemployed below pre covid level
• A marked increase in the number of people not in employment and not searching for jobs – inactive people has increased, adding to labour market tightness.
• MPC sees further bank rate rises needed to return inflation to target and should not increase the bank rate too far, the path to get to target inflation is shallower than the current market implies.

No Near-Term Let up In Inflation

Given the economic outlook, there were questions on the sensibility of raising rates into a recession and Bailey was very clear that inflation would be slain by hook or by crook.

Rates will rise but based on current thinking less than the market is pricing in.

There was also a slide on what I have dubbed the “Fiscal Fiasco Factor” caused by Trussenomics.

The BoE shows that by their measure at least there is some way to go by their estimate to undo the higher yield premium being demanded by investors for UK risk:

In sum the commentary was that markets were normalising but remained “febrile”.

The 2 Year Swap rate used to price fixed mortgages was 4.5% on 22nd September the last BoE meeting.

This peaked at 6% and was 4.38% as of yesterday’s meeting. Things are normalising but there “some” markets were described as still having illiquidity issues.

Undertighting vs. Overtighteining

There was a question of whether the BoE could be at risk of overtightening as is a concern in the US.

The answer was a no – the US is in a much better place economically and has not suffered to the same extent in terms of Gas prices or any of the other fall out of the Ukraine War which is an acutely European problem.

Ben Broadbent pointed to the clear signal that the regional PMIs have given.

At the beginning of the year EUR, US and UK PMIs were 54,57 and 58 respectively – healthy by any means. But the latest figures have Europe and the UK at 47 and the US is now at 58. (There is a reason investors are o/w US credit ve Europe).

Overall the messaging for investors was measured and, caveats aside, point to looser monetary conditions being supported by a weaker economy.

The BoE meetings if all goes as the MPC thinks will not be the market-moving events seen in the US or Europe. That has to be a good thing in my book.

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“What is the market pricing of bank rates post all the Central Bank Meetings?”

I am glad you asked -I had a look at US, EUR and UK rate assumptions before the central bank meetings and what is being priced today.

The big moves were seen in the US rate expectations after Powell’s clear-cut and pragmatic presser, with expectations for another 50-75bp hike in December being priced in with rates expectations through higher along the rest of the OIS curve.

The ECB’s messaging, as always, was walked back. It has seen Lagarde stress (twice now) that rates need to rise to control inflation – as a result, market expectations for bank rates are higher but nowhere near the extent seen in the US and given the messaging and the economic outlook this makes sense.

What makes less sense, to me at least, is what the UK curve is doing – rate expectations are lower at 4.7% vs. the 5.2% used by the BoE (2 weeks old). That seems in line with lower rate expectations.

However, using the BoEs 3% constant rate assumption and its 5.2% market rate assumption, the average of the 2 is 4.1%.

And if we have been told the BoE thinks that the required rate lies closer to 3%’s side of the tracks that implies a destination of sub 4.1%.

UK OIS expectations have moved lower, but not by that magnitude. If the BoE are correct and my very back-of-the-envelope assumptions hold water then GBP risk’s premia should decline.

Please leave your thoughts below in the comment section.

Powell -Higher hikes in the front end – all rate expectations higher in line with messaging

Lagarde – Higher in the long end on the back of increased inflation expectations given the front end anchored. Continues to walk back messaging.

Bailey – no major changes in expectations, with near-term moving higher and long-term lower consistent with messaging

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Week-to-Date Total Returns – GBP Assets, bar High Yield outperforming, USD the laggard.

Asset Class	EUR	GBP	USD
High Yield	+24	+8	-134
Investment Grade	-56	-3	-49
Equity*	+37	+153	-464
Rates**	-244	-85	-159

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Today’s Events

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Eco Data

Today we had UK construction PMI – see what caught our eye below, and we also had the fabled Non-Farm Payrolls in the US which came in at +261k higher than expected but also showed the unemployment rate higher at 3.7%.

Net-net the data supports a hawkish Fed. Next week the focus will be on CPI.

Today’s Reporting

AMC

Adient

Marcolin

Softbank

SPIE

Softbank

Telefonica

What Has Caught Our Eye

UK Housing – More Softness Ahead Part 2.

The UK Construction PMI was published this morning posting modest growth at 53.2 up from 52.3, which is positive and was attributed to the level of new project starts and the pipeline of unfinished work.

However – the survey reported increasing cost burdens and low optimism in the face of an expected economic slowdown.

Overall not a disaster but the decline in optimism ties in with yesterday’s article which highlighted slowing construction growth.

“Business optimism regarding the year ahead slumped in October and was by far the weakest since the early pandemic months. Construction firms cited concerns about a broad-based decline in client demand due to cutbacks on non-essential spending among clients, although some noted that growth linked to green energy projects, planned infrastructure spending and success in niche markets could help to offset the UK economic headwinds.”

Tim Moore, Economics Director at S&P Global Market Intelligence, 4th November

Moodys 2023 Credit Outlook

Moodys have published its 2023 outlook and this article summarises its views for Credit in 2023.

Lots of great info – below are some of the charts that I like. Essentially credit conditions are expected to worsen with an increase in defaults with the consumer and energy-consuming companies most at risk in Europe.

Defaults are expected to rise above the long-term average, but generally, credit is in a good starting position.

Worth the time to read to get an overview of where credit is heading.

Performance

High Yield

Investment Grade

Rates

Equities