CIO Office: Opinions
Chris Iggo, CIO AXA IM Core
Should we worry about valuations in US credit markets?
Credit markets offer investors attractive potential risk-adjusted returns, underpinned by solid fundamentals. However, in the US, credit spreads are relatively narrow compared to their distribution over the last 10 years. The average investment grade credit spread is around 100 basis points (bp) compared to government bonds and for high yield credit the average spread is 320bp. These sit at the 25th and 50th percentile of the respective 10-year distribution. Since the US regional bank crisis of March 2023, spreads have narrowed by 60bps for investment grade and by 200bp in high yield credit, delivering strong total returns of 6%, and 11% respectively. Given where spreads are now and the more uncertain outlook for Treasury yields, we would expect US investment grade credit returns to be closer to their current yield of 5.0%-5.5%, with risks balanced around that range. High yield credit has more opportunity to deliver around 8% total return over the next 12 months.
Alessandro Tentori, CIO Europe
Monetary policy and market-based neutral rate
The natural interest rate (aka r-star) cannot be observed. It is the neutral rate of interest, net of inflation, that supports the economy at full employment or maximum output, while keeping inflation constant. Together with monetary policy anticipation, expected inflation and the term premium, r-star defines the level of risk-free bond yields. In addition to model estimates, we can extract useful information from the yield curve. Currently, a market-based measure of r-star stands approximately 150-200bp above pre-COVID-19 levels (see chart).
The high level of uncertainty around r-star automatically translates into uncertainty about the monetary policy stance. What if the natural interest rate was higher than current estimates? What if the long-run dot (r-star) at 2.6% failed to capture the changing structure of the economy? Evidently, the actual monetary policy stance would not be as tight as is widely believed, in which case risk premia across asset classes are probably too compressed to compensate investors for a scenario of repricing of a new interest rate regime.
Furthermore, this high level of uncertainty comes on top of an economic policy mix, which somewhat dilutes central banks’ effort to control inflation. Expansionary fiscal policy, excess liquidity, the inverted yield curve, and risky assets’ valuations (financial conditions more broadly) could imply that the overall policy stance is not as “tight” as generally believed. In this case, implications for GDP growth, inflation and central banks’ reaction are obvious.
Looking ahead, it is likely the current level of the Fed Funds Rate is above most estimates of the r-star and we feel that markets need to be careful about pricing in too many rate cuts. This in turn has implications for expected returns across bond markets and is a strong support for short-duration strategies in fixed income, especially in an environment of inverted yield curves.
