Continuing inflation is likely to keep interest rates high for longer, say global respondents to the International Association of Credit Portfolio Managers' (IACPM) Q4 2023 Credit Outlook Survey. While credit conditions have improved, the fight against inflation will probably take longer than expected, putting into question recent market optimism, they say.
The last two months of 2023 were overcooked, both on the rate and credit-spread rally fronts, according to Michael Nowakowski, head of structured products at Conning.
"The December Federal Open Markets Committee (FOMC) meeting seemed to give the markets the 'all-clear" and thus we saw a couple weeks of an 'everything rally,'" Nowakowski said. Currently, he considers on-the-run U.S. ABS and agency MBS subsectors, the main participants in the December risk rally, to be "on the rich side of fair value".
As the market comes to terms with the fact that the FOMC may not cut rates as aggressively as the market is currently pricing, there could be a partial unwind of what we saw in December and near-term term spreads could widen, Nowakowski said.
Respondents are still largely expecting worsening credit conditions going forward.
Respondents to the IACPM survey expected that, although credit spread outlooks improved in Q4 versus the three earlier quarterly surveys, they would widen for the CDX North America High Yield 5Y, iTraxx Europe 5Y, and iTraxx Europe Crossover 5Y indices. The exception was the CDX North America Investment Grade 5Y index, which had a neutral outlook.
As for structured credit, Nowakowski is fundamentally sanguine about the underlying collateral. Non-agency RMBS is buoyed by house price appreciation in place since 2020, and in ABS the tightening in underwriting standards since the start of 2023 means the bulk of consumer underperformance is likely at its peak. Equipment, shipping, and travel-related sectors are in good shape, and in subprime auto there is the beginning of a plateau in 60+-day delinquency rates, Nowakowski said.
The view from abroad
Reflecting international market views, the IACPM's survey respondents are less sanguine, leading them to forecast rising defaults. However, their views are more mixed than they were three months ago, according to the IACPM's survey, which is calculated as diffusion indices, reflecting the number of respondents with negative or positive outlooks.
The IACPM 12 Months Credit Default Outlook Index for global average retail/consumer mortgages was minus -53.8 in December 2023, compared with minus -59.5 in September 2023. The retail/consumer mortgage index was minus -89.7 in March 2023.
The IACPM 12 Months Credit Default Outlook Index for global average commercial real estate was minus -67.4 in December 2023, slightly worse than minus -65.3 in September 2023, but an improvement on minus -91.9 in March 2023.
A tough spot for real estate
Seventy-six percent of respondents thought global credit defaults would rise in commercial real estate, while 60% believed there would be an increase in defaults for the retail and consumer mortgage sectors, the IACPM found.
"Respondents are still largely expecting worsening credit conditions going forward," said Som-lok Leung, the IACPM's executive director. "But not as many people believe that now as did before interest rates, such as the yield on 10-year U.S. Treasuries, began to fall in October."
However, risk varies across geographic regions and market sectors. Two thirds of survey respondents do not expect the U.S. to fall into recession, while 69% think the U.K. and Europe are already in a recession or will be by the end of 2024.
Expectation of corporate default rates remained high, with 71% of respondents expecting default rates to rise for North American Corporate, 89% for Europe Corporate, and 29% for Asia corporate.
Nowakowski acknowledges the complex picture of the macro-economic environment with Conning's fundamental outlook for structured credit.
"We are optimistic, but prefer to be patient in adding risk at current rate and spread levels," he said.
