Positive outlook and improving fundamentals

Listen to the full episode to find out about their outlook.

Bernard McGrath: What’s your outlook for credit markets in 2022?

Mohammed Kazmi: From the macro perspective we are positive on credit as we remain confident on the outlook for growth. Although growth is set to moderate this year from high levels, it should stay above trend as the service sector finally normalises. Whilst inflation fears are present, we do expect inflation to moderate during the course of 2022.

From a micro perspective we are also positive on credit given impressive and improving fundamentals. For example net leverage for US IG names has fully reversed the increase observed during the pandemic, whilst a US HY default rate of under 1% for 2021 highlights how this segment of the market benefitted from the reopening. We have a preference for high-beta credit with low duration, favouring subordinated financial debt, in particular AT1s which should benefit from the rising rates environment and high yield given attractive valuations and improved fundamentals.

Bernard: Since the start of the year we have had another bout of rate volatility, with yields moving higher. What explains this move?

Mohammed: At the end of last year it was already clear to us that central banks were going through a period of adjustment. The Omicron variant news was out, however the Fed chose not to use it as an excuse to remain dovish, as we have seen throughout the pandemic. Instead, Fed Chair Powell said that he was retiring the word “transitory” in describing inflation, and the Fed doubled their tapering pace in December.

At the start of this year, the hawkish shift from the Fed has run further as it has now become clear that they will be looking at quantitative tightening, where they shrink the balance sheet sooner than had previously been expected.

This urgency from the Fed has led investors to reprice their expectations as it has become clear that the strong inflation and employment data out of the US means that the economy no longer requires such loose monetary policy.

Bernard: Do you expect such a move higher in rates to continue throughout 2022?

Mohammed: We have passed the peak in central bank stimulus and so we still see room for rates to rise. This is especially the case at a time when hawkish central bank actions are coming from several key DM economies away from just the Fed and ECB. Although we have seen yields move higher, the market continues to price the Fed less aggressively than its own dot plot projections, with 6.5 hikes currently priced for the Fed compared to their own dot plot projection of 8 hikes throughout the forecast period, and so there is room for this gap to be closed.

Bernard: How should credit perform in this rising-rate environment?

Mohammed: So although we see rates rising, we anticipate this move higher to be an orderly one given that our base case remains for global inflation pressures to ease as 2022 progresses. We are already seeing signs of supply-side constraints beginning to improve, as observed with shipping costs starting to normalise and chip production return, whilst commodity price stabilisation should also allow headline inflation to moderate throughout the year.

It’s also worth keeping in mind that central banks are attempting to lift rates for the first time in many years and so they are incentivised to do so in a smooth manner to allow them to lift rates high enough to provide room to cut rates again in a future downturn.

Finally, I think we need to remember that the Fed is turning hawkish not only due to inflation fears, but also as a consequence of the more robust growth backdrop and the rapidly tightening labour market. And this growth environment is a key reason for why we remain positive on credit, as the global economy tries to finally move beyond the pandemic this year.

Bernard: What are the main risks to the outlook you have described that we should watch out for this year?

Mohammed: Firstly on the pandemic, our base case is that we move away from lockdown-type measures this year given the high vaccination rates. However, we cannot rule out another severe variant that manages to escape vaccine protection and this would impact our positive growth scenario. That said, what this latest wave has shown us is that vaccines have done their job in decoupling case growth and fatalities. And so whilst another variant could impact growth in the near term, we now have the infrastructure to develop a booster shot to cover such an adverse scenario within months, which should limit this impact.

The second main risk is on inflation. Whilst we do expect it to moderate as the year progresses, there is a risk that it is once again more persistent than initially thought where supply-side constraints do not fully recover. This could lead to even more hawkish central bank action which could result in another volatile move higher in rates. This is why we think it makes sense to hold low duration at this current juncture.