June 2022 Credit Market Update:
Things That Go Up for $500, Please
The Federal Reserve is now in exactly the spot it wanted to avoid. Inflation is rampant, and because of the long pause before raising rates while the Fed argued inflation was “transitory,” it is now locked into a path that limits its options and narrows the runway to a soft landing.
The June inflation print at 9.1% isn’t just the highest number in 40 years (that one is getting old), it’s the psychological effect of the so-far failure of the Fed’s interest rate moves.
We are two months into an aggressive rate-increase regime, with a surprise 75-basis point month last month, and inflation still came in WAY over consensus expectations.
Chairman Powell was candid in his remarks last month that it wasn’t just the strong labor market and uptick in inflation in May that pushed them to the 75-basis point increase; it was also the University of Michigan consumer sentiment survey on inflation expectations coming in higher.
Inflation can be a self-fulfilling prophecy in that expectations of inflation tend to become reality.
How did we get here? The Fed has reiterated for months that it would be data-driven and make adjustments as new numbers came in. But it appears the only numbers it was looking at were on the Big Board. The “Fed put” that was backstopping equities was arguably the priority.
Intransigent supply chains and a reluctant labor force aren’t responding as quickly as hoped, and the ongoing war in Ukraine is pushing energy prices up. Most of the 9.1% increase was energy, and we have already seen that come down in recent weeks. But core CPI (excluding food and energy) increased as well. At least a 75-basis point increase in July now appears the most likely option – and a higher rate increase is certainly on the table.
The other economic self-fulfilling prophecy? Recession. The Fed wants to control inflation while also maintaining the stated goal of full employment. Slowing the economy through monetary policy, without breaking it, isn’t a precise science because the chain of impact has too many inputs. If consumers and corporations believe that rate increases to combat inflation will result in overshooting, pullbacks in spending behavior – the nicely named “retrenchment” will become a powerful force that can push the economy into recession.
How Did the Credit Markets React?
It was the worst first half of the year for equities since 1970, and the lowest performance for the Bloomberg U.S. Aggregate in the first six months of the year since the inception of the index. The index was down 1.57% in June and returned -10.35% year-to-date. Year-to-date, U.S. Treasuries returned -9.34%. While interest rate increases were largely the cause of the price declines, pessimism about the prospects for the economy resulted in spread widening in June. Bonds were negative across most sectors, with emerging markets and high yield down the most year-to-date, followed by investment grade corporates.
The 60/40 portfolio is struggling. With equities and bonds moving in tandem, diversification is hard to come by.
A Closer Look: It’s All About Inflation and Interest Rates
Demand is increasing for assets that can provide some inflation relief and help mitigate the effects of a rapidly increasing rate environment. In the credit space, loans that are structured with floating rates are seeing increased demand.
There are two loan asset classes that are linked to a short-term benchmark rate, usually either the Fed funds rate or SOFR. In private credit, direct loans are a bi-lateral agreement between lenders and private companies, and are typically structured as floating rate notes. Syndicated or leveraged loans are commercial loans provided by a group of lenders. The loan is structured, arranged, and administered by one or several commercial or investment banks.
Direct lending and leveraged loans offer lower correlation to bonds and equities, and while they are below investment grade, they are usually senior, secured notes that are high in company’s capital structure and are backed by the assets of the company.
Performance Among Credit Indices
Source: Bloomberg as of 7/7/2022
Chart Spotlight: Diversifying on the Income Side
Direct Lending: Historically Higher Returns
Source: BofA Securities, Bloomberg Finance L. P., Clarkson, Cliffwater, Drewry Maritime Consultants, Federal Reserve, FTSE, MSCI, NCREIF, FactSet, Wells Fargo, J.P. Morgan Asset Management. * Commercial real estate (CRE) yields are as of September 30, 2021. CRE-mezzanine yield is derived from a J.P. Morgan survey and U.S. Treasuries of a similar duration. CRE-senior yield is sourced from the Gilberto-Levy Performance Aggregate Index (unlevered); U.S. high yield: Bloomberg U.S. Aggregate Credit – Corporate – High Yield; U.S. infrastructure debt: iBoxx USD Infrastructure Index capturing USD infrastructure debt bond issuance over USD 500 million; U.S. 10-year Bloomberg U.S. 10-year Treasury yield; U.S. investment grade: Bloomberg U.S. Corporate Investment Grade. Data is based on availability as of May 31, 2022.
Credit Asset Classes
Other Related Asset Classes
