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Views from the credit desk: Bullish and Bearish Cases

2021 has seen a wide dispersion in asset price returns, driven by a more inflationary environment. Commodities, stocks and high-yield are up, but investment-grade and government bonds are down. In our latest Credit Pulse we consider the case for bullishness and bearishness about corporate conditions and the global economy, and suggest ways that credit investors can act on either sentiment.

When considering the case for bullishness and bearishness, we find it helpful to break our analysis up into three fields:

The bullish case:

Economists expect a synchronised global recovery because of Covid-19 vaccinations, with pent-up demand from consumers who have been forced by lockdowns to rein in their spending. In any case, governments are getting better at targeted lockdowns that reduce economic harm. Moreover, global case numbers appear to be on a downward trajectory.

Fiscal and monetary policy is highly supportive. A fiscal example is the US federal government’s plan to spend $2.3tn on infrastructure. A monetary example is European Central Bank asset purchases.

It should be possible to contain inflation unless global demand shoots up, given the slack within labour markets. For example, although US jobless claims have fallen to their lowest levels since the pandemic began, they are still higher than before the pandemic.

The bearish case:

Research by The Economist suggests the actual global Covid-19 death toll could be four times or more above the official toll. Going forward, there are variants of concern that could increase deaths and disrupt the global economy, such as the Indian variant B1.617.2. Even where vaccination has gone well, in some cases momentum is stalling either because the remainder of the population is not participating or because doses are not available. In any case, large swathes of the global population are not being vaccinated yet.

Inflation also presents a worry. There is some risk of a stagflation environment: low economic growth, but with inflation. After all, there were concerns about growth even before Covid-19. Moreover, prices have risen. For example, as people return to their offices, they may well notice that the price of sandwiches has increased considerably. This may be because retailers are trying to make up for lost time, because their input costs are higher or their output capacity is restricted.

The bullish case:

Earnings have been pretty strong from a base of high expectations coming into 2021. For example, of the 489 S&P 500 companies that have reported quarterly earnings for the first quarter of 2021, there was a 23% aggregate earnings surprise1. Of the companies that had reported, negatively. Overall, S&P 500 companies showed earnings growth of over 48%, year-on-year.

Balance sheets in general are in decent shape. Net leverage for investment-grade bonds is below where it was before Covid-19. Although high-yield leverage is currently still quite high, it is set to drop because of expectations of strong earnings growth. We expect companies’ interest coverage to increase to close to a record high. This should provide a cushion against rising rates.

Corporate default rates are expected to peak at a low level. Moody’s says the global high-yield default rate is likely to have peaked at only 6.8% in December 2020. In previous recessionary cycles it has tended to peak at between 10 to 13%.

The bearish case:

Default rates are low because of huge central bank and government support. However, this has to be unwound at some point.

On the consumer side, although default rates for mortgages are low, this is because of payment holidays and income from temporary furlough schemes. There have been requests for payment holidays in many different countries, which have had varying levels of regulatory support. In any case, furlough schemes and payment holidays will eventually have to end and the true level of arrears and defaults will become apparent then.

Recovery rates during the Covid-19 crisis have been low. The rate is 45 cents on the dollar for loans and bonds, according to US statistics from Moody’s, compared with 59 cents in 2008–9. For loans only, the rate is just under 50 cents, compared with 70 cents in 2008–92. Some of that is due to doc-lite, some of it is due to corporate structures and some to the capital structure underneath the loans – albeit a mix which has so far led to fewer defaults than expected.

The bullish case:

The increasingly powerful push to a new green global economy will admittedly produce losers, as fossil fuel demand declines. However, it will also produce many winners, as investment in clean energy grows. The International Energy Agency said in May that clean energy investment needs to more than triple by 2030. This will create millions of new jobs and lift global economic growth. Many companies will be on the right side of regulation, and able to take advantage of this megatrend.

We believe that the likelihood of highly disruptive social unrest in developed economies, because of high income inequality, is low. Peaceful redistribution is more likely, because of growing awareness of this problem. 

The bearish case:

There are signs that some markets are becoming rather frothy. This is often a precursor to bear markets. For example, the S&P equity risk premium total return index, which measures the return spread between stocks and long-term government bonds, is at its highest point since 2000, just before the dot-com boom. This indicator has peaked before other large market moves since then. There is also a craze for retail investing in cryptocurrencies, which seems to be based on fashion more than fundamental beliefs.

The geopolitical environment presents risks. These include unrest in the Middle East, tensions between the US and China and the continuing political implications of Brexit, which has encouraged secessionist tendencies in Spain and Scotland.

Watch the Credit Pulse debate entitled, 'Bull vs Bear'.

  1. 1Bloomberg, as at June 2021
  2. 2‘Lenders struggle to recoup losses after US corporate debt defaults’, published by the FT in May 2021.

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