October 2022

Credit Risk Monitor: Fundamentals in focus

Fundamentals in focus

Significant volatility in credit markets made for a challenging third quarter, as hope for a peak in inflation was eclipsed by higher service and housing cost pressures. Leading economic indicators are deteriorating rapidly, while central banks continue to be laser-focused on inflation. Markets have prepared for a likely policy mistake, reflected in spreads widening to levels reflecting a high probability of a global recession.

Jim Cielinski, CFA
Global Head of Fixed Income

Approaching the peak

  • Inflation rates could climb higher before they peak, igniting fears about sticky inflation that is on the rise, but in US, for example, base effects should start to wash through from October.
  • Rate volatility remains the driver of credit spread volatility rather than corporate stress, but this could change as the market focus shifts to fundamentals.

Earnings weakness to broaden

  • Lower earnings revisions were focused in specific sectors, but this is now broadening out across more industries and we expect earnings to be revised meaningfully lower over the next two quarters.
  • A liquidity-induced downturn in the cycle is set to morph into a fundamental downturn, as the inventory overhang could lead earnings growth to fall off sharply in the next six to 12 months.

All signals turn to red

  • All three of our indicators are red, indicating that the credit cycle is weakening, but also flags to investors to keep an eye on an inflection point in policy, earnings or economic growth.
  • Spreads will peak before defaults as the latter are a lagging indicator and while spreads reflect a lot of risk already, they could widen further with a weakening in credit fundamentals and thus credit quality.

Volatility ahead

  • Post the pandemic, companies have refinanced debt, pushing out maturities well into the future. This should reduce stress in the system, and lead to a shallower default cycle than seen historically.
  • The central bank put – where they ride to the rescue of markets or the economy – is no longer with us, but signs of their retreat from the relentless pursuit of tightening could be a sign to add risk in portfolios.
  • Episodes of volatility could offer better entry points as greater dispersion between sectors or inefficiencies across markets rises and so a nimble approach – alongside caution in adding credit risk – feels warranted.