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2023 Outlook - High Quality Credit Spreads

FICC Podcasts Podcasts December 15, 2022
FICC Podcasts Podcasts December 15, 2022

 

Dan Krieter and Dan Belton discuss their outlook for credit in 2023. Topics include spread targets, relative value, the fundamental and technical factors likely to drive credit, swap spreads, and the risks to their outlook.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter: Hello, and welcome to Macro Horizons High Quality Spreads for the week of December 14th, 2023 outlook. I'm your host Dan Krieter here with Dan Belton, as we bring you our expectations for credit and swap spread markets in the new year. Each week, we offer our view on credit spreads ranging from the highest quality sectors such as agencies and SSAs to investment grade corporates. We also focus on US dollar swap spreads and all the factors that entails, including funding markets, cross-currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or email directly at dan.krieter, K-R-I-E-T-E-R, @bmo.com. We value and greatly appreciate your input.

Well then, before jumping into our 2023 outlook, I think it's important to set the table with where we are now in credit because we have just seen a fairly significant rally in credits spread over the past couple months. Opening this morning at 136 basis points on the ICE BAML index, we are now narrower than post-crisis averages and near somewhat important technical levels we've talked about a few times here, where we've seen three consecutive credit rallies peter out in the 135 to 140 basis point range. That's where we're going to start next year. So I guess we'll start very high level Dan and just start with what are some of the main themes you're expecting to drive credit spreads in 2023?

Dan Belton: From a high level, I'm expecting this rally that we've seen to continue on through the early part of the first quarter. I think we're going to see this optimism that we've seen on more benign inflation data and expectations for a less hawkish Fed early on in the year. And I think that's going to continue to support credit spreads. I'm looking at about 120 to 125 basis points as potential lows early on in the year. And then later on the second and third quarter, I'm expecting credit spreads to run into some stronger headwinds.

We typically see credit spreads widen based not on inflation or Fed policy uncertainty, but on fundamentals in earnings. And I think that's going to drive the narrative later on in 2023. So as fundamentals start to deteriorate, given a more restrictive Fed, I'm expecting credit spreads to start to migrate to a wider trading environment, just given our expectations for a more challenging environment to persist in 2023. Our base case is for a shallow recession. And in that case, I'm expecting credit spreads to peak right around where they peaked in 2022 and then find some stability later on in the second half of the year. And we're forecasting spreads to finish 2023 at around 150 basis points, just modestly wider than where they're set to start the year.

Dan Krieter: I think I wanted to head into 2023 with a bullish call on spreads to expect some nearing, but given the magnitude of the rally we've seen to end 2022, I think that the narrowing potential somewhat limited here. I do think current levels are a fair target for the end of 2023, maybe more likely just slightly wider. And going back to what you said about the beginning of the year, I agree with you. I think the Q1 could represent a bullish outcome for credit spreads. First, there's the macro drivers we talked about already. But secondly, seasonals are generally very supportive in the first couple months of the year. And I think that could be especially true in 2023 after a very challenging 2022. I think investors will look at the current level of spreads, look at the current level of yields and want to put money to work particularly with the Fed in the process of pivoting monetary policy to at least the less hawkish Fed, however you want to describe holding rates in restrictive territory at flat levels.

So I do think Q1 will be constructive for more tactical traders. I think that being long heading into the year is attractive. To your point about the target being 120 basis points or so, I don't see the potential for a very significant narrowing. So for investors with a longer time horizon, maybe a bit less opportunistic, more of a neutral rating on credit heading into Q1. Could be appropriate because to your point, Q2, Q3, I do think will start to see some more weakness in spreads. And my overarching view on the credit market here is that spreads will remain elevated to post-crisis norms, what's been the prevailing trading environment for most of the past decade really, because of a different Fed stance to a slowing economy, which is expected in being Fed manufactured at this point. You look at the last two significant economic slowdowns, both 2008 and 2020, we saw the Fed coming in with massive liquidity. And to some extent, at least short circuiting the typical downgrade default cycle you see coming alongside slowing the economy.

But it's not just those two major exogenous shocks that maybe should be viewed as outliers. Anytime in the past decade, really where we see economic growth start to slow, 2015, 2018, 2019, even back to 2011, the Fed has responded pretty aggressively on the accommodative side. Now, the Fed will be less restrictive this time, but the Fed stated goal is to try to hold rates unchanged for most of 2023 in restrictive territory. Now, maybe towards the end of the year we see a move back towards neutral. But from an absolute perspective, we're going to see a monetary policy in a restrictive stance for most or all of 2023. And I think that we haven't really seen a full downgrade default cycle play out arguably since before the financial crisis. Now, that isn't saying that we're calling for a massive wave of downgrades default. There will probably be a pickup there.

But even as that risk of a slight increase in downgrades and default activity, we should see spreads remain elevated to the yield grab that really prevailed for much of the post-crisis environment. So if that holds true, we should see current levels of spreads as some approximation of fair value, if not towards the tighter end of the new trading plateau and credit, which really does provide further rationale for the year end call at the end of 2023 in the 150 basis point range on the broad index. So I think we're in agreement there. I want to spend a minute here talking about some of the risks to our base case, Dan. And why don't you start with giving us the risks to spreads being narrower than we're forecasting in the new year?

Dan Belton:  Well, I think certainly in light of the recent CPI prints, the biggest risk that I'm seeing to narrower spreads in 2023 than we're forecasting is the potential for inflation to continue to moderate much quicker than many are expecting. And this scenario would see an accommodative Fed back in play, which was of course the driver of historically supportive credit conditions throughout much of 2021. If there's any perception of the Fed being back into accommodative territory, cutting below neutral, even if it doesn't happen in 2023, expectations that that's back on the table would really support credit and I think bring spreads through that 120 basis point level that we talked about at the top.

And then a second scenario, and one that's also become increasingly likely in light of these benign CPI prints is the possibility that the Fed does engineer a soft landing. And that we get inflation continuing to come down, but it doesn't come alongside a significant spike in the unemployment rate. And then credit concerns, even if corporate fundamentals get a little bit worse throughout 2023, it doesn't spark a significant downgrade wave. And I think then we would see as there's less macro uncertainty, credit spreads would likely finish the year narrower than at 150 base point level and narrower than long-term averages.

Dan Krieter: And then on the wider side, there are two pretty obvious risks I think to our base case. The first one is inflation fails to moderate here, that risk looks more subdued now, particularly after the various supportive CPI report in December. But we're not completely out of the woods on the inflation standpoint. Yet, there is historical evidence to suggest that inflation tends to be sticky, particularly after high inflationary periods. There's concerns about the China reopening and what that could mean for demand fueled inflation. Still, we haven't seen unemployment really tick down at all. Consumers remain very healthy by all accounts at the moment. So there is still risk to inflation remaining elevated. Certainly now at a base case, I don't think either one of us thinks that, but we have to at least acknowledge the possibility. And then second risk to a wider than our base case and spread scenario is a severe recession which will really come in one of two ways.

The first would be a rapid and significant increase in unemployment or some type of contagion event. I think the contagion event scenario is one that can never be foreseen or discounted. I would just say on that front, we have seen unprecedented monetary policy following the pandemic and now an extremely swift tightening of financial conditions. The ingredients are there for some type of cracks that have been under the surface quickly coming to light. And there is still concerns overshadow banking sectors in less regulated pockets of the market. Obviously, not something that we're expecting, but a risk that we have to at least acknowledge. And I think the key point here is even as recently as a couple weeks ago, if I was going to assign probabilities to these risks, I probably would've assigned a higher probability toward one of these widening risks actually taking place and of seeing a soft landing or seeing a central bank more accommodative than we think.

But the economic data has really been supportive. Now to your point, Dan, about a soft landing increasing in probability. So maybe the risk to narrower spreads than we have in our base case has grown and maybe now outweighs the risks to wider. So maybe potentially some rationale there for expecting spreads to be a little bit narrower than we're expecting.

But either way, I think that in 2023, no matter how the economy unfolds, what we're going to see in 2023 is a decline in the importance of inflation and the Fed's actions to fight inflation, which really drove spreads of 2022. Those are likely to fade at least a little bit and we're going to see a return of more traditional drivers of corporate spreads. Fundamentals, earnings, things of that nature. So I think we should see credit differentiation likely to have an increased focus in the new year and for fundamentals to be what drives spreads. So in light of that, Dan, why don't you give us an overview on where we are from a corporate fundamental standpoint and maybe what you're expecting in terms of rating migration in the scenarios we've laid out?

Dan Belton: Yeah, so fundamentals were very strong in the high grade market throughout 2022. We only started to see a little bit of deterioration with the third quarter earnings. We saw cash ratios fall, profit margins really compressed, and interest coverage ratios move a little bit below their record peaks that we saw earlier in 2022. And so we're expecting more deterioration in 2023 as the impact of higher costs, higher interest expenses continue to feed through to corporate balance sheets. And that's going to be exacerbated by the potential for a weakening consumer. Lighter revenue streams and earnings which have been very supportive throughout the post pandemic era are likely to continue to get a little bit worse as a result. And it's worth noting that while fundamentals were very strong in the high grade space throughout 2022, that's not really what we saw further down the credit spectrum. And in the high yield space, with the exception of the highest rung of borrowers, we saw a pretty significant degree of credit deterioration within high yield.

So if we're looking at rating actions, while investment grade rating actions were positive on average throughout most of 2022, we saw upgrades outpaced downgrades by nearly 500 billion at the index level on net in investment grade. Whereas in high yield, we saw significant net downgrades, which really accelerated in the second half of the year. So that's something to watch and we're expecting that deterioration and high yield to start to creep into the investment grade market in the early part of 2023, even though we haven't yet seen that happen at this point in the cycle. And the last thing on rating migration: Rating migration painted one of the most supportive pictures that we've seen on record in terms of migration into and out of the investment grade market. We saw just over a hundred billion in rising stars or in debt that was upgraded from high yield to investment grade, where just 43 billion in fallen angel debt. And over half of that fallen angel debt was due to Russian sanctions.

So not really reflective of broad corporate distress, but really just due to a geopolitical event. So that net 60 billion in upgrades from high yield to investment grade is the most supportive that we've seen on record and really even understates the health in the corporate market. But we're expecting that to start to reverse a little bit next year. We're calling for about a hundred billion in fallen angel debt from the index in 2023. And that really underpins our preference for single As moving a little bit up in quality. Not to the highest rung of quality in the investment grade market, but up from the triple B segment in addition to some relative value that resides there.

Dan Krieter: Yeah, wanted to go to relative value next, so you've beat me to the punch there. And I think some of the things you talked about with high yield and the downgrade rates that we saw in high yield markets really wasn't reflected in spreads. If you look at decompression across the credit spectrum this year and you compare it to historical widenings, this year was an outlier because we didn't see lower rated credits really underperform. If you look at widening as a percentage of total IG widening, high yield to triple B widening and triple B to A widening was among the second or third lowest observations of any widening since the turn of the century. However, if you look at the widening between A'S and double A's, it was the largest percentage of any widening we've seen in the past 20 years. So A is really underperformed this year.

I think part of that of course has to do with the fact that financials comprise a much larger percentage of the A rated bucket than either double As or triple Bs. And we know that financials underperformed this year among an onslaught of supply, so that's part of it. But even removing the financial aspect of it and looking at just A rated industrial indices versus double A industrial indices, we still see spreads for A rated segments elevated compared to historical norms. So I think that's an important point: When you talk about the downgrade activity in high yield expectations for more fallen annuals out of triple B into high yield, this all painting a picture for likely more spread decompression into 2023. It underscores the value in up in credit trades. We like the A rated tranche certainly, but I'd also highlight relative value in even above the A rated segment in double A's and in SSAs, the extremely high credit quality segments which have underperformed during the narrowing of the past couple months.

It's not extreme relative value, but there is at least some. And given this expectation for more credit differentiation next year for 2023 to remain a challenging environment for credit, picking up on that relative value now really seems to be attractive to me. And then the other thing from an RV perspective is just a steepness in the spread curve between the short end and the belly. And we're off the extreme observations that have been there for much of the second half of the year. But still short end belly spreads remain attractive. And I think if we're expecting growth fears to mount in 2023, that typically coincides with flattening spread curve. So from a macro perspective, that's an attractive trade. But also when you look at some of the demand technicals of 2023 and the flows that drove the market, I think that brings slight a technical steepening that we can maybe expect to reverse in the new year as well.

Dan Belton: And Dan, moving on to flows and the demand side technicals that we're expecting to impact credit markets in 2023, just looking at last year, we saw significant buying in US dollar corporates buy insurance companies and foreign buyers. And insurance companies actually overtook foreign buyers as the largest holders of US dollar corporate debt according to the Fed's Z one data. Insurance companies talking about here, life insurance and PNC insurers saw $880 billion of inflows into the asset class this year. Foreign buyers were a surprisingly strong source of demand for corporate debt this year, given the elevated hedging costs that they face. But nonetheless, were a strong buyer of corporate debt this year. On the other hand, we had significant outflows unsurprisingly from funds this year. So mutual funds, ETFs, closed-end funds saw a decline in their holdings this year after a pretty significant run up in 2020 and 2021.

And then the household sector, which we typically equate to hedge funds: We're also significant net sellers in 2022. So moving on to 2023, we expect flows are going to be pretty strong from pension funds, which remain very well funded, which typically implies stronger demand for fixed income. Insurance companies are going to continue to rotate into corporates as they have in the past couple years. And we're expecting that mutual funds and ETFs are going to see some of these outflows that they've seen over the course of most of 2022 start to reverse, as the asset class finds a little bit of stability. And that should become a positive source of demand for US dollar corporates in 2023. But foreign buyers remain a big question. I think on one hand you're going to see this policy divergence between the Fed and the BOJ for instance, which is going to keep hedging costs very elevated relative to historicals, which should be a headwind for demand from some foreign buyers.

But on the other hand, if the dollar continues to come off of its peaks, that should be somewhat of a tailwind for demand from that class of borrowers. So on that, we're expecting foreign demand to move a little bit lower but remain a positive source of demand for US dollar corporates in 2023.

Dan Krieter: And then I think really the last major component of the 2020 tail we have to recover here before we wrap up. It's already quite a long episode here. I think we have to talk at least a bit about the supply expectation of 2023. We did talk about this in greater detail in our last podcast recording, so we won't go into too much detail here. If you want that depth, go please listen to the last high quality spreads on the Macro Horizons feed and you'll get the deeper drill down into the driver's supply and what we expect. But for today, let's just hit the high level bullet points on supply in 2023 and how it informs the view. Dan, let's start with you and IGs.

Dan Belton: Yeah. We're expecting 1.275 trillion in gross IG issuance. That's up from this year, which is set to finish around 1.22 trillion. So we're expecting a modest increase, but still below the levels that we saw in 2020 and 2021. I think one of the major wildcards is going to be the breakdown between financial and non-financial borrowers. Of course, 2022 was typified by extremely heavy financial supply and extremely light non-financial borrowing. So I'm expecting that to reverse. Financial borrowing is likely to moderate, whereas issuance by industrials, utilities, should move a little bit higher as we see, as corporations look to rebuild their cash ratios, rebuild liquidity, particularly in the event of potentially worsening revenue streams.

Dan Krieter: Then very quickly on the SSA side: 2022 was the most supportive year, technically speaking for SSAs on record and net's issuance of negative 54 billion. Foreign funding was a major driver of that, but also just market volatility and lower SSA supply in general. Looking ahead into next year's supply, technical should remain supportive. We forecast negative 14 billion in net supply. So while remaining supportive, the tailwind from the supply side will be less strong in 2023 than it was in 2022. And just quickly January, obviously the most important month of SSA supply every year. We've seen weaker demand from banks and central banks, the two biggest constituents for the SSA market in recent months. That has certainly improved in the past couple weeks alongside the rally in credit in general and a dropping dollar. But the calendar in January is quite limited. We have lunar new year following this year in January, so the windows for issuance are going to be relatively constrained this year.

So I think that means we're going to see crowded days with multiple borrowers on any open window, which could mean upward pressure on concessions and SSA markets in the beginning of the year. Some upward pressure there with technicals likely to improve thereafter. And quickly before we go, just want to give our outlook for swap spreads in 2023 made somewhat easy by where we're entering the year because we are near historical lows. Albeit a short history and SOFR swap spreads, but we're near the lows. And 2022 was almost a perfect storm for narrower swap spreads with four main drivers putting downward pressure on the market. The biggest one of course was central bank intervention, but we also had significant uncertainty over the path to Fed policy, very poor liquidity and strong supply from financials that all put downward pressure on swap spreads. Looking into next year, all four will likely improve, particularly liquidity.

While QT will continue to remove reserves from the system, I think increase in liquidity potentially from regulation, from an improvement in bank balance sheets and from an improvement in foreign demand, will outweigh the illiquid pressure from QT with liquidity ultimately improving slightly. And so we're looking for swap spreads to widen over the course of 2023. We could see a period of underperformance in the middle part of the year where we're expecting the debt ceiling to be a significant political risk in 2023. The Republicans have already laid out their desire to use the debt ceiling to try and win some concessions for Democrats. Certainly the midterm elections make that less likely. But even since the midterms, we have seen Republicans continuing to foreshadow another contentious debt ceiling showdown. And the narrowing pressure on swap spread: Some of the debt ceiling will be most acute towards the middle of the year. So we could see spreads coming down a bit in the middle part of the year.

But over the course of the year, expecting widening, maybe not of a very strong magnitude. Certainly, everything we've covered in this episode with a lot more detail, a lot more backing, can be found in our written 2023 outlook. So please go there to get more detail on any of the outlook for creditor swap spreads in 2023. This will be our last podcast episode of the year. So I just want to take a moment to thank all of our listeners for tuning in over the course of 2022. Your support is very meaningful to us. And so a very sincere thank you and we hope you have a very happy and safe holiday season.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton, B-E-L-T-O-N, @bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including the FICC macro strategy group in BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3: The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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