Credit Q&A: how to navigate a choppy second half of 2023

The volatile start for the year for credit markets has calmed somewhat over recent months and it appears that the major economies have managed to avoid a deep recession. However, with Europe still adjusting to the latest interest rate hikes by the European Central Bank (ECB), high inflation and low growth remains a struggle there and elsewhere.

Against this backdrop it looks like volatility might pick up again in the second part of the year. We caught up with Julien Houdain, Head of Global Unconstrained Fixed Income, and Martin Coucke, Portfolio Manager Credit, to discuss how credit investors may need to position themselves and where they can find steady income to protect against both inflation and price depreciation.

What is your outlook for the remainder of the year and what tips do you have for navigating in the current environment?

We expect the economy to continue to slow down. It looks like the developed markets recession that was expected in the first part of the year has now been delayed, most likely to the second part of the year. The optimism around the Chinese re-opening is fading as well, with the latest figures showing weaker than expected growth.

Nevertheless, we expect any recession to be pretty shallow. And there are positive signs: the monthly rate of inflation, for instance, has slowed down quite a bit already due to the quantitative tightening measures taken by central banks, and that is likely to continue. There might be a few more hikes on the horizon but in general it looks like the central banks are beginning to wind down, at least for now.

The current environment is tricky to navigate, so careful security selection remains critical to driving returns. Credit investors should also keep an eye on the amount of risk they’re taking on and the duration of their portfolio to factor in the economic slowdown and to provide a better cushion against the current rate environment.

It seems that the months of quantitative tightening seem to be working and the latest inflation figures seem rather optimistic in the US and Europe. What are your thoughts on inflation going forward and how will the turning tide affect your strategy?

It indeed looks like the tide is starting to turn. The market definitely seems to agree as it’s currently pricing in a meaningful drop in inflation over the next 6 to 12 months. So the terminal rates are probably close to their peak, at least in the US. It might take a bit longer in Europe, but even there we should be close to terminal rates. The UK should follow soon after that. However, despite the inflation tide turning we can still expect to operate in a high inflation, high interest rate environment for longer, which will keep volatility higher too. Events such as the UK gilts crisis, and more recently the turmoil in the US banking sector, are good examples of how things can change very quickly in the current environment. Agility is an important trait as investors need to be able to react fast and efficiently to any turmoil on the market.

Strategy-wise the current environment can be very unforgiving to companies, and over the coming months we expect see an increase in defaults. This is also already reflected in the valuations.

So flexibility is important?

Yes, definitely. Active bond selection is crucial as it helps investors to avoid the pitfalls in volatile markets. The focus needs to be on picking the right names and to avoid the blow ups. There are currently several scenarios as to how things might progress from here, so investors need to be on their toes. If the economy takes its time to slow down, inflation might start rising again. That would force the central banks to raise interest rates even further. So far the economy has remained surprisingly strong, excluding a few cracks on the banking sector, so that’s definitely something to keep an eye on. That’s why it’s important to be flexible and able to change your views depending on what we observe on the market and what the latest data is telling us.

Going back to volatility and the banking sector, what are your current thoughts about it? After the collapses of Silicon Valley Bank and Signature Bank and more recent failure of First Republic in the US, and UBS acquiring Credit Suisse in Europe, do you think the problem is now contained or might we see an escalation of things in the future?

It’s important to separate the US and European sectors. The US banks operate in a world of their own and the market is very fragmented. The smaller US banks are also much more exposed to commercial real estate than their European peers, which means that we're not seeing the same amount of deposit outflows in Europe that we’re seeing in the US. Ultimately it was mainly the lack of regulation that led to the US banking crisis. The Credit Suisse bankruptcy was more of a result of years of mismanagement rather than a more systematic problem in the European banking sector itself.

So the current turmoil is much more US-centric and we do remain cautious. However, the US banking sector should be able to weather the storm pretty well. The market has already widened a lot in terms of credit spreads, although nothing has happened. There are actually many interesting opportunities available at the moment if you know where to look.

Besides the financial sector, are there any other sectors or themes you are currently focusing on?

Considering we believe the economy will continue to slow down and that we’re likely to see more defaults in the future, investment grade corporates are a way to go. Companies with BBB ratings and good fundamentals are currently offering decent premiums.

Looking at different themes, defensive companies that provide stable income despite market volatility should fare better in this environment than their more cyclical counterparts. Focus should be on companies with resilient and sustainable business profiles with a good ability to generate cash flows to serve potentially higher financing costs. Real estate is the sector currently standing out and is probably the biggest alpha opportunity as spreads are close to all-time wide levels. Despite the headwind coming from higher interest rates, there has not been a significant deterioration of fundamentals as rent indexation to inflation has offset the negative impact coming from higher yields. The European logistics sector looks particularly interesting, as it is still prone to benefit from further adoption of e-commerce. Here, Europe is still bound to catch-up with more advanced countries like the UK or the US.

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