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Credit Matters

2022: Setting Opportunity for 2023?

December 2022


The Covid-19 pandemic recovery hopes that lifted risk assets in 2021 all but disappeared in 2022, when both stocks and bonds were hit by surging inflation, the outbreak of the Russia-Ukraine war and a subsequent energy crisis. To top it all, pandemic fears kept China in stringent lockdowns for most of the year, while the crypto universe plunged following some high-profile bankruptcies. Yield curves inverted and the S&P 500 posted its biggest annual decline since 2008.

Credit spreads widened, pushed by protracted recessionary fears. High Yield (HY) outperformed Investment Grade (IG) in both Europe and the US, as its shorter duration was a benefit in a year of record rate hikes around the world. US rates, for instance, stated 2022 at 0.25% to end at 4.5%. The fastest ever Fed rate hiking phase came as inflation reached 9.1%.

UK gilts and corporate bonds underperformed, hit by the additional effect of a convoluted political year: the market reaction to an attempt to cut taxes and increase spending sent politicians around the world a stark message: a reversal of the ongoing Quantitative Easing-to-Quantitative Tightening (QE to QT) trend is not welcome.

The US dollar surged against most currencies, backed by a rising interest rate differential, especially against the yen. The
Japanese currency reduced losses towards the end of the year, when the Bank of Japan announced a softening of its yield curve control policy. The country’s 2-yield rose above zero for the first time since 2015, practically bringing an end to the years of negative yields that followed the 2007-08 Financial Crisis.

Investors in alternative asset classes, such as Hedge Funds with the capacity to go both long and short and some momentum and directional strategies, outperformed given their flexibility. Some selective Credit and Asset-Backed Security (ABS) strategies were also successful as prices fell to near-distressed levels before showing some recovery in a year marked by volatility. ABS and Loans were also helped by their floating-rate nature.

The uncertainties that dominated last year seem to continue in 2023: inflation may be stickier than expected; the Russia Ukraine war is ongoing; China continues to battle against Covid19 and most economists expect a global recession.
This backdrop, combined with the attractive prices that 2022 left behind, may bring opportunity in 2023.

Latest Manufacturing Purchasing Managers’ Indices (PMI):

▪ Euro-area December: 47.8
▪ China December: 47
▪ US November: 49
▪ UK December: 44.7

*Figures below 50 are considered contractionary*


Source: Bloomberg as at the last business day of the month indicated at the top of this report.

Theme of the Month: Credit is Cheap

Figure 1: S&P 500 Equity Risk Premium – US High Yield Spread 

Credit is cheap 

After a year of record interest rate hikes, no wonder Fixed Income (FI) asset classes ended the year on the cheap. Bonds suffered for a second year in a row, as 2021 penalised the asset class in detriment to Equities, which surged on expectations of a post-pandemic reopening. While stock indices suffered in 2022, they are still behind FI in terms of pricing uncertainty and the (still unconfirmed) recession that most economists foresee.

This timing mismatch has left Credit attractively valued relative to stocks. As seen in Figure 1, the difference between the risk premium between both asset classes has increased (green area, right axis), as Credit spreads (blue line) have widened relative to the Equity Risk Premium (ERP, black line). This may be due to the fact that last year’s equity sell-off was largely driven by the higher equity discount rate, derived from the higher interest rates, rather than by any pessimism about future earnings: the US S&P 500 Index trades at 17.5 times its 2023 expected earnings, very close its long-term average of 17.4 times – hardly a recessionary sign.

The Credit repricing in 2022 has led to attractive yields: as seen Figure 2, European and US HY indices yield more than 8% (on a currency unhedged basis), substantially higher than the 3.75% seen barely one and a half years ago.
Investors willing to clip bond coupons may have attractive options in 2023.

Figure 2: 2023: Good Times for Yield


Source: CQS as at 3 January 2023. Yields are presented in the base currency of each index, and therefore on a currency unhedged basis. Yields may change substantially once they are currency-hedged.