Deutsche Bank with the note:
As we close out 2021, it is fair to say that this year has been one of the lowest vol years for credit on record. A perfect calm of the strongest growth for decades, coupled with still extreme level of stimulus has resulted in very low spread ranges.
We think this low vol environment is unlikely to last and spreads will sell-off at some point in H1 when markets reappraise how far behind the curve the Fed is. Even with covid restrictions mounting again in Europe as we go to print, we think it’s more likely that we’ll be in a “growthflationary” environment for 2022. We think the overheating risk is more acute than the stagflation risk, especially in the US. Strong growth and high liquidity should mean that full year 2022 is a reasonable year for credit overall but if we’re correct they’ll be regular pockets of inflationary/interest rate concerns in the market, which we think is more likely to happen in H1.
At the H1 wides, we could see spreads widen as much as 30-40bps in IG and 120-160bps in HY which is consistent with typical mid-cycle ranges through history. We do expect this to mostly retrace in H2 as markets recover from the shock and growth remains decent and liquidity still high. However, with the potential for a shift in the narrative to potential late-cycle dynamics, we think spreads will close 2022 slightly wider than they are today. We will be watching the yield curve closely through the year for clues as to how the cycle will evolve into 2023. This has the ability to move our YE 22 forecasts in both directions as the year progresses…
The most realistic worst case scenario for 2022 is one where we enter a stagflationary environment, where growth grinds to a halt and inflation remains elevated or climbs even higher. Clearly this will be a notable spread widener.
We think it’s more likely that we’ll be in more of a “growthflationary” environment for 2022. Policy remains highly stimulative around the world and financial conditions loose. This is especially true in the US. There are also some relatively easy early year comps (H1 2021 lockdowns/restrictions) and still room for economies to catch up to their pre-covid level of activities. As such we think the overheating risk is more acute than the stagflation risk. Strong growth and high liquidity should mean that full year 2022 is a reasonable year for risk assets overall but if we’re correct there will be regular pockets of inflationary/interest rate concerns in the market. To be more precise, we think there’s a decent chance that markets attack the Fed’s well choreographed forward guidance at some point in H1 when its clear
that inflation will remain elevated for longer than the market and the Fed has recently expected. In some ways the recent premature stagflationary fears have helped the low vol environment as they have provided an excuse for central bank caution. However as growth reignites after a weak Q3, we will have the double whammy of higher growth and still high inflation. This will likely lead to the market reappraising front end rate markets, especially in the US.
This will knock spreads out of their low vol slumber but will likely be good buying opportunities as we don’t think the cycle is vulnerable for at least the next 18 months. It’s possible that by late 2022, the market is concerned that the cycle ends in 2023, and such a risk needs to be reflected in our spread view. However 2022 should still see positive excess credit returns point to point.
Figure 3 shows DB’s 2022 growth and inflation forecasts across a selection of important countries. As can be seen it’s hard to argue we are going to be anywhere near close to stagflation in 2022. The definition of stagflation differs from person to person with our preference being a genuine move towards or below zero percent YoY real growth with notably higher than targeted inflation.
Our favourite lead indicator of the business cycle remains the US 2s10s curve. Over the last 70 years and 10 recessions, this curve has always inverted before a recession with an average lead time of around 12-18 months. The only time it was far too early was in the mid-1960s when the Fed made a well-recognised (ex-post) policy error and cut rates instead of raising them as was expected. As such the yield curve re-steepened out of inversion before inverting again a couple of years later as they corrected part of their error by belatedly raising rates. The US then went into recession with the usual lead time.
At the moment there still feels like there is plenty of steepness in the yield curve to not worry about an end to the cycle within at least the next 18 months. However it is fair to say that the curve has failed to continue the steepening seen in H1 2021 and has got stuck, with October seeing the curve flatten back below +100bp for a brief period (from a March ’21 peak of +158bps) as global markets fretted that short-term rates would go up and would choke off the recovery. So this will be one to watch in case we’re wrong and also in terms of mark-to-market volatility even if we’re nowhere near levels yet that suggest the imminent end of the cycle.
In fact, we would still say there is as much chance of overheating than seeing a serious growth slowdown, especially in the US…
This stimulus past and present and ultra-loose financial conditions, means that the US economy will have closed its output gap by around the start of 2022, with the unemployment gap likely closing before the end of Q1 22.
As Figure 7 shows this will be around the quickest the US economy has closed these gaps since this data was first calculated. It’s also a complete contrast to that seen after the GFC where it took until the end of 2017 for the output gap to close – some eight years after the crisis. This is a very different recovery to the post-GFC one and it would be a mistake to assume similar things happen. The output gap will soon close in an environment where the savings rate remains artificially high which is related to the extreme money supply chart above. If consumers decide to spend down these savings quicker than anticipated then we could easily overheat…
When we look at measures of employment tightness that correspond best to wages, it already looks like the US economy is behaving like it’s beyond full employment. Figure 8 shows this by looking at the US quits rate versus the real ECI…
Our bias is that for the US economy at least we are more likely to see overheating than a disappointing growth environment. As such we expect there to be more pockets of volatility than seen in 2022 as markets battle central banks on front end rate hikes. Central banks will want to stay behind the curve, partly due to a belief that inflation is transitory and partly due to a desired policy stance (post FAIT), but the market will likely attack that as the data shows that inflation is more permanent and we’ll see a tug of war throughout the year, likely at its most intense in the first half.
Ultimately the economy should stay strong and liquidity will remain high. So that should ensure risk assets are structurally supported but we would expect moments when markets battle central banks, especially the Fed. US credit will likely underperform European credit when this happens.
Whether we start to worry more structurally about the cycle in H2 2022 will likely depend on the outlook for 2023, and perhaps more simply whether the curve flattens substantially by then. This is most likely to happen if the Fed are expected to become notably more aggressive and the market either thinks this is because of a policy error or if demand for bonds simply overwhelms the back end. The midterms will come into view but at this stage the market must surely be pricing a very high probability of a split government and fiscal gridlock. So its hard to see this being a major macro event outside of a high degree of headlines.
Our base case for now is that spread volatility picks up but that it’s a buying opportunity and spreads rally back even if they finish 2022 a bit wider than where they started it.
The base case is also for higher yields and there will no doubt be lots of talk about the impact that this will have on credit spreads.