Opportunities in credit

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European credit has been under pressure from the fear of stagflation, credit exposures to Russia and an illiquidity premium. However, the market has had time to price in the credit risk and to sell what had to be sold (ex-Russia). Furthermore, the shape of the stagflation risk as well as the ECB response are by now well understood. We view European credit (e.g. High Yield, Banks…) as currently offering a point of entry that typically does not last very long. Furthermore, we expect the market to be more focused on stable returns offered by fixed income in the coming months.

1. Fear of stagflation

The fear of stagflation linked to much higher energy prices is still rocking the markets though we remain far from oil levels comparable to previous oil shocks (e.g. 1970s) if we take into account that we are far richer today. Brent peaked close to 130 dollars and is now around 110. One might wonder if buying credit is the best option to sell the risk of a stagflation scenario:

War is costly and Russia desperately needs the dollar revenue of oil and energy; it won’t massively curtail output unless it is completely cornered. This is something the Europeans will strive to avoid, Europe having no incentive to leave Russia without a way out. Other members of OPEC might consider increasing output to cool down this price inflation. Then CDS such as the itraxx cross-over and the embedded put options in High Yield map the region of fear very well with a likely better risk/reward than equities. Finally, the ECB’s reaction function is now well understood. The APP programs ends in Q3 and a hike is likely after. This means that in a few days, peripheral bond markets should have priced in the new more hawkish ECB.

2. Credit exposures to Russia

Foreign banks have at least 120bn dollars in exposures to Europe based on BIS banking statistics, with a French and Italian bank often cited. Some investors have portfolio exposures to Russian bonds, and some corporates have direct investment exposures such as in the automobile industry. Much of this is known, though surprises are possible when some interlinkages are opaque.

3. Liquidity premium waiting to be absorbed

In a crisis, the most illiquid asset class typically comes under pressure first and moves the most. This is a function of a specific premium attached to it, namely the need for liquidity as the market moves to cash and short duration positions. This premium is a function of risks being shifted by one group to another that is in short supply (limited number of risk takers) as Keynes, a macro investor, once postulated. Risk has hence both a supply and demand and a concept of liquidity that are interlinked. We had seen some signs of caution on European High Yield ahead of January and since then it has strongly underperformed (see Graph of the Itraxx cross-over below).

What does it mean? The conditions are there to move back into European credit based on the limited risk of a sharp stagflation, well priced-in credit exposures to Russia and an illiquidity premium to be captured.

Source: Nordea Investment Funds S.A. and Bloomberg

 

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