Although the pandemic certainly ended one economic cycle and began another, the Covid-inspired downturn was relatively brief. In the wake of the economic downturn, massive monetary stimulus and fiscal bailouts muted the credit cycle and limited the number of defaults. Within two months, the US economy was expanding and the cycle began again.
Even though this current cycle is barely two years old, we nevertheless see storm clouds on the horizon. Inflation continues to run hot. To fight it, the Federal Reserve is committing to hiking interest rates, which is usually enough to end most economic expansions. Global debt is at unprecedented levels. Yet undaunted by the prospect of rising rates, animal spirits are surging, with new records of leveraged finance issuance being set. And economic growth is starting to stutter.
This creates challenges for credit as a whole: the end of accommodative monetary policy, a growing stock of debt and slowing economic growth to finance it all.
We might not just be facing a recession, but the end of credit cycle as well.
Investors brace for slower global growth as European recession expectations grow
Against this trickier macro backdrop, it is worth considering which credits may face a challenging time ahead.
In contrast to staples, as incomes shrink in real terms, consumer discretionary credits may well be among the first to suffer. Likewise, we believe industrials and other cyclical firms geared to the performance of the wider economy may struggle if the cycle ends.
What is clear to us is that this is an environment where selectivity and name selection remains imperative and not an environment where you want to own the entire market which is the goal of passive strategies.
A more challenging macroeconomic backdrop in 2022 is likely to expose the fundamental problems with the composition of high yield credit indices, which are tracked by passive funds and ETFs and closely referenced by benchmark-constrained active funds.
Investors often do not realise how concentrated credit indices actually are, with more than 25% of the global high yield index being comprised of the top 50 issuers. This means they will be owned by passive funds and high yield ‘tourists’, income investors and investment grade investors.
However, we often think these can be particularly poor investments during periods of volatility because they are usually the first things investors historically tend to sell. And this year we expect more volatility with a change in monetary policy direction, entrenched inflation and increasing pressures on many businesses.
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These issues will be particularly evident in the US, which accounts for the vast majority of the high yield index. Around 77% of the market is US-denominated debt and we think is a problem because of the most acute pressures we see building in the US. Therefor passive and benchmark-constrained funds may find things more difficult this year, particularly as the backdrop becomes more volatile.
No-one is going to get rich just owning the market.
From a sector perspective, there are increasing opportunities in consumer staples, healthcare and telecoms.
These types of credits were out of favour just 12 months ago, but we like their pricing power and ability to cope with cost pressures. The high yield universe is very large – managers could potentially invest in more than 1500 names – but you do not want to own all of them and you do not want to overdiversify.
If you look at the largest and most commonly used high yield ETFs, even though they are meant to replicate the market, they generally have delivered a lower return than their benchmark over the long run with higher volatility.
Investors must have a high conviction in high yield and invest only in the credits they think will perform well.
Mike Scott is credit manager at Man GLG