Why It’s Time For More Caution Toward Credit Markets by Richard Turnill, BlackRock
BlackRock Global Chief Investment Strategist Richard Turnill’s chart of the week shows why it’s time for more caution toward credit.
As I write in my new weekly commentary, it’s time for more caution toward credit. My chart of the week helps explain why I’ve downgraded my view of credit to neutral from overweight.
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U.S. high yield bond spreads neared recession levels in February, as prices declined and yields increased. Since then, credit markets have rebounded sharply, despite rising default rates, as you can see in the chart above. Behind the rally: returning inflows amid firming oil prices, diminishing recession fears and a more dovish Fed.
After the rally, high yield isn’t cheap anymore. With spreads approaching their 15-year average, the bonds no longer price in a high risk of a U.S. recession. Spreads remain above typical levels associated with an economic expansion, but they’re reflective of today’s low-growth world highlighted by back-to-back quarters of around 1% annualized U.S. gross domestic product (GDP) growth.
We view the risk of a recession as low, yet acknowledge default rates are ticking up. Moody’s sees the U.S. default rate rising to 4.7% in the next year, as the chart above shows, given deteriorating credit conditions in sectors sensitive to declining commodity prices. A BlackRock analysis of spread levels shows defaults could be even higher. We believe Moody’s may underappreciate the potential spillovers of weakening credit availability for commodity issuers into other sectors.
We still prefer credit to sovereigns and high yield to investment grade (i.e. investors are still being paid to take risk/carry). However, after the recent run, we are reducing our weighting to U.S. credit. We generally prefer non-dollar credit to dollar credit, with quantitative easing (QE) from the European Central Bank (ECB) providing support for euro credit markets. Read more in my latest weekly commentary.