Kempen Capital Management: 3 scenarios for credit investors

15 juli 2022

After a long period of low inflation, interest rates around zero and soaring financial markets, Kempen Capital Management sees that investors are now confronted with issues they haven’t experienced for many years – high inflation that has been much more persistent than expected and, for the most part, hawkish central banks. To make matters worse, this comes against the backdrop of a full-blown war on the edge of Europe and a pandemic that hasn’t completely gone away. The result has been a hugely challenging first half of the year for bonds, with the iBoxx Euro Corporates index down around 12.5% year-to-date as at the end of June. 

But what comes next?

Kempen’s Euro Credit team envisages three main scenarios from here. 

Scenario 1: Muddling through (70% probability)

In Kempen's core scenario, inflationary pressures persist, to which central banks continue to react by tightening monetary policy. This results in a slowdown in economic activity but helps cool inflationary forces.

High interest rates cause a relatively brief recession, and unemployment increases but remains low from a historical standpoint. Eventually, inflation falls to a level moderately above central bank targets and markets calm down, leading to buying opportunities for long-term investors. Over the longer run, inflation proves stickier than expected as governments find it hard to rein in spending and wage demands rise against a backdrop of low unemployment. Long-term inflation expectations rise steadily.

What about the prospects for credit investors in this scenario? The team believes credit losses would increase initially to slightly above their long-term averages from today’s very low levels, and most of the losses and credit downgrades would be concentrated in a few sectors, such as real estate and industrials. The banking sector should perform relatively well due to its derisked balance sheets and strong solvency levels and the positive impact of higher rates on banks’ earnings capacity.

In this scenario, the iBoxx Euro Corporate index spread would widen further from around 150 bps at the end of June to 165–190 bps. This is a relatively high level in historic terms, but, according to Kempen, one needs to bear in mind that until recently government bonds have generally been providing ultra-low yields: when government bond yields were yielding -0.5%, the extra 100 bps of yield that a basket of corporate bonds provided looked a lot more attractive than when government bond yields are trading at 3% and credit spreads at 125 bps. What’s more, the proportion of BBB issues – the lowest credit rating within investment grade – in the index has risen steadily over time, warranting higher spreads to compensate for the higher credit risk such issuers involve.

Scenario 2: Hope (15% probabilty)

In Kempen's optimistic scenario, inflation falls back below the magic 2% level more quickly – within 12–18 months – than rate markets are currently pricing in. This is due to a combination of slowing economic growth, aggressive central bank tightening and easing supply chain pressures. Credit and rate markets rally aggressively whenever supportive data points are published. Fundamentals, valuations and technicals are mostly supportive, and the iBoxx Euro Corporate index’s spread tightens to around 70-75 bps.

Scenario 3: Fear (15% probability)

In Kempen's final, most pessimistic, scenario, inflationary pressures keep building up and central banks make policy errors that worsen the situation for capital markets. A relatively severe recession ensues, leading to spikes in bankruptcies and credit losses. A high level of uncertainty leads to a liquidity crunch that involves extremely sparse trading of bonds (this has already happened three times in the past 20 years so is by no means unthinkable). Spreads rise to around 250–300 bps, depending on the severity of the liquidity crunch.

In this scenario market participants expect the ECB to stop hiking as soon as the eurozone falls into recession as they believe doing so would be good for the equity and credit markets. But the team believes this would be a major policy mistake that would result in inflation remaining high. In such an environment it would take a long time for fundamentals to turn positive again and technicals would remain negative in a liquidity crisis, so spreads would need to be very high to compensate for the risks that investing in credit involved.