Faced with a complex macro backdrop, central banks will be seeking to deliver “goldilocks” policy normalization to keep inflation in check and neither too hot nor too cold. An unwind of easy macro policies, high inflation and virus uncertainty is somewhat counterbalanced by positive economic and corporate earnings growth alongside healthy private sector balance sheets (see our Outlook 1Q 2022). This backdrop, combined with technical factors, creates interesting opportunities in credit markets.
Macro and corporate conditions are consistent with an early- to mid-cycle environment and we believe the strong growth backdrop continues to support high yield (HY) bonds, where we see attractive relative value compared to historically low credit losses.
Bank loans benefit from the rising rate environment that accompanies high inflation regimes given the coupons on bank loans reset higher alongside a rise in rates.
US bank loans generated 5-6%1gains in 2021. We think they will deliver positive returns in 2022, benefiting from attractive valuations and fundamentals. Last year, robust corporate profit growth and above-trend economic growth led to a historic decline in leverage loan default rates to a range of 0.3%-0.7%, well below the long-term average of 3%.1
Financials, particularly banks, tend to benefit from an environment of higher inflation and higher interest rates. Lending and net interest margins increase, boosting profits, and asset quality generally performs well. Our research also shows that in an inflationary environment, credit spreads for banks can tighten versus industrials (excluding energy-related companies).
Fundamentals across financials are also in good shape, notably at US banks, where balance sheets have strengthened and many reported robust 2021 profits from high merger and acquisition (M&A) activity and trading volumes.
Given the strong fundamental backdrop, we think some US banks are attractive at current spreads. Part of the reason is technical. Last year, an unprecedented volume of supply drove spreads wider, particularly in A-rated credits, and at a time when A-rated risk underperformed. This year we expect much less supply, which could lead to tighter spreads.
We prefer US over European banks based on diverging inflation and interest rate outlooks as well as current valuations. We expect the US Federal Reserve (Fed) to raise rates four times this year with risks skewed to the upside, while we think the European Central Bank (ECB) will keep policy rates on hold until 2024. Spreads between large US and European banks are also tighter than usual, suggesting relatively attractive valuations in the US.
We see three main risks to our view. First, valuations are already high across a number of fixed income sectors, requiring investors to be selective. Second, “over tightening” by central banks is a possibility. Current inflation reflects some one-off conditions, such as fiscal stimulus and excess savings, meaning it could dissipate in 2022. In particular, balance sheet runoff is expected to occur soon after rate liftoff; a compressed timeline on liquidity withdrawal relative to the last cycle could challenge risk assets including corporate credit. Lastly, the economic impact from COVID may be receding but the risk of a variant that evades immunity remains (see our Outlook 1Q 2022).
Each month we feature quotes from our investment team, offering a glimpse into our investment views and what we are monitoring and analyzing.
“Credit fundamentals are being bolstered by the historic decline in corporate default rates.”
— High Yield Research Team
Goldman Sachs Asset Management Forum | January 2022
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