Credit Market Daily #66 %author %

04-January-2023

Good Morning!

We are back – Happy New Year!

With the new year come investment outlooks and the FT, Bloomberg have compiled and summarised a whole bunch of Buyside and Sellside research.

Over the coming days, I will summarise what I have been reading in “What Has Caught Our Eye” below.

On Today’s menu are Apollo and Standard and Poors.

Consensus is certainly for the first half of ’23 to be weak, with most seeing recessions being relatively shallow with the UK being the underperformer.

Light risk positioning is also consensus as is the preference for fixed income on expectations that it will shine. Volatility and “choppy” markets are also something most expect.

There are no real changes to the default outlooks – most companies will weather the storm, having secured liquidity. However, creditworthiness is expected to decline with those more cyclical / consumer-led industries expected to struggle the most.

There are some great charts below so I encourage you to read or skip to the end.

One of the fin-Twitterati puts it well:

In 2022 the Monkeys didn’t pay attention to the Income Statement to their detriment

In 2023 the Monkeys will not pay attention to the Balance Sheet to their detriment

2023 = The Year of the Balance Sheet

Think of it as Hunger Games, but with Balance Sheets

🙏🥲🌳
— Le Shrub 🌳🔥👹🇺🇦 (@agnostoxxx) January 2, 2023

Tesla remains in the headlights (geddit?). As mentioned previously I see this as a canary in the coal mine that fundamentals are finally going to challenge valuations.

The slow hiss of asset bubbles deflating will continue with the odd pop causing investors to sit up.

It will be no different in credit than it is equity, especially for borrowers with limited access to markets.

Today we have the FOMC minutes which will likely prove a catalyst today as investors parse them for hints of “pauses” or “pivots”.

French CPI has surprised to the downside this morning -0.1% MoM vs. 0.4%, this will be taken positively by markets as it potentially gives them more room to breathe.

However, the ECB made clear that it anticipates inflation in the Eurozone to improve and then increase as fuel price rises are passed through to retail consumers.

We have 4 weeks until the next round of central bank meetings and plenty of Central Bank speak to come so I expect the volatility to continue.

Credit Relative value below. Overall valuations are fair to expensive relative to the last 12 months, with breakeven spreads still offering decent protection.

Overall I think my target of 500 on Xover (currently 446, -15bps on the day) is reasonable.

Credit

High Yield

Quickly looking at relative value:

GBP HY remains the cheapest (unsurprisingly) relative to EUR and USD based on spread and Breakeven Z-scores
Overall, despite the recent weakness in equities High Yield looks to be fair to slightly expensive based on the last 12 months
I would expect dispersion within the asset class to increase as the gap between winners and losers increases
Spreads have yet to price in any fundamental weakness – this should pick up in Q1/2.
Given valuation – relative value is the name of the game
Cash and supply will both continue to be supportive of spreads

Leaders and Laggers

Investment Grade

It is a similar story for IG, with valuations erring on the more expensive side as investors view the asset class as being positioned to offer better risk-reward than High Yield and Equities.

Long duration into a Central Bank Pause or Pivot will likely be rewarded but require a leap of faith that inflation and growth play out as consensus believes.

Financials are one sector that actually has a positive rating bias in Standard and Poor’s 2023 outlook.

Outside of this sector rating biases are much as you would expect given the cyclical outlook.

What Has Caught Our Eye

Apollo 2023 Economic and Capital Markets Outlook

This is well worth a read and written by DB’s ex, and Now Apollo’s Chief economist Torsten Slok.

The full outlook can be downloaded here.

If there is one chart that I would point you to it is the gap between S&P earnings and GDP growth expectations as 2023 will be about fundamentals and discovering what fair valuations are.

For reference consensus estimates of S&P 500 EPS for 2023 are currently at $231. Morgan Stanley has $195 is one of the more bearish forecasters, but it gives some idea of where we are and where we could end up.

Aside from the above, the other thing that stuck out was that Apollo sees a soft landing in the US as something that the Fed could achieve and is not to be dismissed.

Other interesting points are on the origin of inflation not being cut and dry, with implications with supply-side inflation falling. Despite this, the analogue of the 70’s suggests that inflation can take a long time to tame and markets may be undercooking the length of time rates may need to remain elevated to reach the FED’s 2% goal.

For Credit they expect Private Credit to continue to fund those issuers who will not have access to the public debt markets and that overall given maturity profiles Investment Grade Credit and High Yield will not experience sudden stop events.

High Yield performance will be driven by dispersion, with stressed and distressed opportunities increasing and relative value important for performing credit.

“To recap: The sequencing of how the Fed reaches its dual mandate (taming inflation and maintaining full employment) is key for capital markets. Receding inflation first, moderating employment later would mean that the need for “demand destruction” on the part of the Fed will decrease. We think that is already happening in the US. We believe a less aggressive Fed—or a potential Fed “pivot” later in 2023—should be bullish for asset prices (public and private) ranging from rates, to credit, to equities. That said, capital markets will remain vulnerable in 2023 and volatility will likely persist because with inflation at high levels and the Fed keeping rates elevated, capital will remain scarce and expensive, and high-yield primary credit markets will stay virtually shut down for the time being. Selectivity in asset selection, valuations, and entry points” will be paramount
Torsten Slok, Apollo

Standard & Poors Global Credit Outlook 2023: No Easy Way Out

Whilst Apollo’s ’23 outlook recognises the possibility of a soft landing Standard and Poors’ piece sees any soft landing as a remote possibility.

Their outlook can be downloaded here.

This report is much more focussed on the downside risks (as you would expect) with the Authors arguing that policymakers and CEOs have little in the way of wiggle room when it comes to dealing with any upsets in ’23.

Despite the doom and gloom the charts tended to point to credit being relatively well positioned – overall default rates are expected to increase but to historical averages and not in excess of those under the base case.

Indeed, S&P’s forecast for Speculative Grade corporates’ Leverage and % of Issuers with Negative FOCF improves in their base case. See below, with dispersion in credit outlook being determined by sector and starting fundamentals.

Cash on balance sheets hoarded in the pandemic is declining and is approaching long-term averages.

The pace of the decline in cash balances is going to be what sorts the winners from the losers in ’23.

The consensus appears to be that primary markets will remain subdued certainly for the first half of the year and so performance is going to be driven by avoiding the losers.

With their base case appearing manageable I think the real takeaway is that any deviation to the downside results in a larger worsening of credit outlooks.