Credit markets are experiencing some relief as inflation data indicates a cooling of price pressures, but concerns about a weakening economy are looming over corporate debt. The high-yield credit market’s perceived risk gauge has eased to its lowest level since March following lower-than-expected inflation in June. However, there are underlying risks that could surface if the Federal Reserve fails to orchestrate a soft landing and the economy slows too much, potentially leading to higher credit downgrade and default rates.
Economist Vishwas Patkar of Morgan Stanley highlighted the current softness across various economic indicators, cautioning against further economic slowdown. Signs of emerging weakness include eased hiring and wage growth, a rise in the jobless rate, and a contraction in services activity. Economic forecasters predict a 30% chance of a recession within the next year, emphasizing the need for careful economic management.
While inflation is no longer the sole concern, EY Chief Economist Gregory Daco warned against excessively restrictive monetary policy potentially weakening employment growth and the overall economy. Despite these warnings, credit investors are currently undeterred by the risks, flocking to debt sales to capitalize on high yields. Risk premiums in both high-yield and investment-grade bond markets remain tight due to strong demand outweighing supply.
Some investors are shifting focus away from the US market after a strong performance this year. For instance, Amundi SA favors European investments at the moment based on valuations. Despite the optimism in the credit market, concerns remain about a potential US downturn, although it is not the base case for Morgan Stanley. The recent string of US data has prompted some investors to reevaluate the growth outlook.
As the focus shifts from the Federal Reserve to the underlying economy, investors are closely monitoring potential developments in the credit market. Leveraged finance bankers anticipate a revival in mergers and acquisitions in the second half of the year, while US company pensions are poised to invest more in corporate credit. Additionally, investors in global Additional Tier 1 bonds are taking profits after a historic rally, and the global artificial intelligence trend may drive demand for energy-intensive data centers, potentially boosting sales of green debt.
In conclusion, while the credit market remains buoyant, it is essential to monitor economic indicators and potential risks closely. As investors navigate the evolving landscape, staying informed and vigilant is key to making informed decisions in the ever-changing credit market environment.