After a horrific Q3, investment grade credit spreads are now trading at multi-year levels. Before considering the global fundamental and interest rate outlook, it is worth confirming just how cheap these valuations have become.
The UK market is now trading as cheaply as any point over the past 10 years, apart from a brief period at the onset of Covid in March 2020. The recent domestic political turmoil - including some quasi-emerging market behaviour from the UK Government - is unarguably responsible for this incremental risk premium.
While euro investment grade credit has not suffered from the same political ineptitude of late, it is also trading at its cheapest level in over a decade, again with a brief exception in March 2020.
US dollar credit has been a relative safe-haven compared to its UK and European counterparts, with a less extreme sell-off. Nonetheless, valuations in the US investment-grade credit market also look compelling on any longer-term perspective. Apart from March 2020, the US market has only been cheaper once in the past decade, when there were concerns over the viability of the US oil sector in mid-2016.
Aside from looking at the absolute spreads available across global investment grade, the valuation argument is supported by break-even rates. This is essentially the amount of incremental widening in credit spreads that would be required to wipe out the current credit yield and produce a negative return for investors (assuming government bond yields are static, which we will come on to below). In the case of the European investment grade market, which has a duration of around five years, we would need to see spreads widen by a further 40-50 bps from their current levels of c. 230 bps over for this to happen.
The fundamental reason that we are trading at such attractive valuations is because of entrenched inflation, and concerns over how aggressive central banks will have to be to control it. The marked outperformance of the US investment grade market in 2022 - relative to euro and sterling equivalents - is being attributed to how hawkish and decisive the US Federal Reserve has been in communicating its desire to address the inflation issue. In contrast, the ECB and Bank of England have both been rather ponderous, although their recent actions and communications have improved markedly from the first half of 2022.
Our view is that the current expectations for rate hikes across the main markets - but especially in the UK and Europe - are overdone. Forward-looking surveys of inflation in the US, such as prices paid and delivery times, have fallen a long way from their highs, indicative of previous pandemic-induced inflation starting to weaken.
It is also likely that the income hit from inflation that consumers are facing globally will start to act as a natural brake on consumer demand, and therefore inflation. These factors should mean that the current expectations of rates peaking at close to 5% in the US in Q1 of 2023, and 5.3% in the UK by mid-2023, are probably overdone. Indeed, one could make the argument that UK rate expectations may even fall further, should domestic fiscal policy normalise after the recent ill-advised foray away from conventional treasury orthodoxy.
Investors who have been long cash through the worst of the volatility will be very pleased with that decision, but with the yield-to-worst on the global aggregate index now above 5.5%, a re-evaluation of asset allocations may be due. We view current valuation levels across global investment grade credit as extremely compelling, and our broadly constructive view on interest rate markets provides additional fundamental and valuation support for this case.
Disclaimer:
For Professional Clients only and not to be distributed to or relied upon by retail clients.
The principal risk of this service is the loss of capital. Please note that other risks will be present.
Opinions and/or example trades/securities represent our understanding of markets both current and historical and are used to promote Aegon Asset Management's investment management capabilities: they are not investment recommendations, research or advice. Sources used are deemed reliable by Aegon Asset Management at the time of writing. Please note that this marketing is not prepared in accordance with legal requirements designed to promote the independence of investment research, and is not subject to any prohibition on dealing by Aegon Asset Management or its employees ahead of its publication.
All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice.
Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority.
AdTrax: 5065187.1 Exp Date: 31 October 2023.
