Fundamentals

The fundamental backdrop is dominated by rampant inflation, ongoing war in eastern Europe and tightening monetary policy. A strong first-quarter earnings season in both the US and Europe largely reflected the pricing power of corporates amid persistent supply constraints and the continued rebound in demand for services. However, these results are largely in the rear-view mirror as inflation anxieties feed into worries over longer-term growth. Central banks continue to emphasise their desire to tame stubbornly high inflation through rate hikes and balance sheet reductions, even at the expense of growth. It therefore seems inevitable that corporate margins will be under pressure from both elevated input costs and slowing consumer demand. Furthermore, tighter financial conditions mean that after a decade of low yields, virtually all borrowers are now facing higher borrowing costs. Even though corporate balance sheets are generally very strong, we believe that fundamental improvement is now behind us in the current credit cycle.

Quantitative valuations

Investment grade (IG) and high yield (HY) spreads have increased dramatically this year amid broad market turbulence. Notably European HY and IG spreads have widened by about 260 basis points (bps) and 100 bps, respectively, off their lows in January. These markets have underperformed their US equivalents as investors have discounted the more proximate impacts of the Ukraine crisis as well as the greater potential for a European Central Bank (ECB) policy misstep, increasing the risk of recession. Looking at historical data covering 11 recessions back to the 1950s, IG spreads tend to price in a recession at around 240 bps, though they can naturally also overshoot in particularly volatile periods. The US IG market is currently pricing a 40% probability of recession, whereas European IG is pricing in closer to 70%. We expect these probabilities to increase over the coming months, and while investors should not expect all-in risk asset capitulation, elevated spread volatility is likely in the near term. While history can be a guide as to when valuations become attractive, we may be entering a new regime for credit compared to the past decade of ultra-accommodative monetary policy. To be more constructive on forward-looking valuations, we would need to see a de-escalation of war in Ukraine, or, at a minimum, signs of inflation beginning to roll over. (All data as of 29 June 2022).

Spreads across the ratings spectrum in the US and Europe have widened dramatically this year

Source: Bloomberg. Data as of 29 June 2022. EUR IG: ICE BofA Euro Corporate Index; US IG: ICE BofA US Corporate Index; EUR HY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index; US HY: ICE BofA US High Yield Constrained Index. OAS: Option Adjusted Spread.

Technicals

Lacklustre retail demand for both IG and HY continues to characterise the deteriorating technical backdrop. Since bond fund inflows had been aligned with accommodative central bank policies, it is logical to think investor outflows will continue as monetary tightening continues. Notably in Europe, the withdrawal of the ECB’s Corporate Sector Purchase Programme (CSPP) marks the exit of the “buyer of first resort” in the European credit markets. US IG markets have witnessed consistent week-on-week outflows over the past months. Secondary liquidity is dire in US HY, with investor positioning reaching new bearish milestones. On supply, when European IG market conditions are calm enough to bring forth new issuance, elevated “new issue premiums” are likely to cause secondary spreads to re-price wider. In European HY, the ongoing lack of primary activity helps, but is not enough to compensate for continued outflows and poor secondary market liquidity.

About the Bond Bulletin

Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.