EUR Credit Strategy: the unpredictability of central banks’ paths going forward will put more pressure on credit spreads in 1H22

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We still see a vulnerable backdrop for EUR IG credit as deteriorating liquidity offsets still-supportive fundamentals. The road to the key central bank meetings in March will be bumpy, and we expect further hawkish communications as we see no respite in inflation figures in the coming months. Maximum optionality by central banks regarding the timing, magnitude and pace of their monetary policies implies rates volatility will continue in the immediate future.

2022 can be defined as a year of strong fundamentals, low default risk and weaker technical factors, both from the supply side (increased issuance driven by M&A and the super-capex cycle) and the offer side (central banks fully engaged with the trio of tapering, rate hikes and quantitative tightening). Uncertainty will not abate until inflation has decisively peaked and begins to decline.

The data-driven and data-dependent short-term paths laid out by the ECB and the Fed will offer little support for risk assets in February-April. The trajectory of policy normalisation over the next few months in the eurozone will be sizable.

The Pandemic Emergency Purchase Programme (PEPP) ends in March and the favourable discount rate on Targeted Long-Term Refi Operations (TLTRO) ends in June, while QE will gradually be tapered, but at a faster pace than we previously expected. Monetary tightening is not by definition negative for credit spreads, unless it is expected to trigger a recession.

We are constructive on 2H22 when carry-driven strategies should gain traction again due to steeper and higher rate curves and wider credit spreads as the volume of negative-yielding debt has been dramatically reduced. Growth and inflation should also be slowing by the year-end, lessening the urgency for central banks to tighten, resulting in more predictable and measured monetary policies.

We have revised up our estimated spread widening for 2022 in EUR IG and HY to the upper end of our initial range: iBoxx EUR IG NFCs Senior (+20bp to 75bp) and the iBoxx EUR HY (+50-75bp to 350-375bp), with some overshoot likely in 1Q22. Any more substantial widening would need a significant slowdown in GDP to be priced in.

The recent spread-widening has resulted in attractive entry points in the asset classes we expect to outperform in 2022 on a relative basis due to their more favourable technical backdrop, characterised by limited supply and low-QE sensitivity (i.e., subordinated financials/insurance debt, corporate hybrids and HY). We expect spreads to begin to widen from 2H22 once inflation has clearly peaked and provided the growth outlook remains supportive.

Long EUR HY vs. EUR IG and long Financials vs. NFCs are ways to play a scenario of rising real rates and accelerated tapering. The ECB is likely to raise its inflation estimates for the 2022-24 period in the March meeting, which will very likely result in the path of net purchases for 2022 being reduced from the original guideline announced at the December 2021 meeting.

The hawkish pivot from the ECB brings the prospect of accelerated tapering of net corporate bond purchases (from EUR76bn in 2021 to c.EUR40bn), while NFCs will need to deal with gradually less supportive earnings seasons, increasing capex and margin compression, along with high inflation, a tight labour force and supply-chain constraints.

The markets still need to fully recalibrate their monetary policy expectations – a process we think could last for most of this quarter. Central bank hiking in a scenario with significantly lower GDP growth is the main risk for credit spreads in 2H22, as it would bring us closer to a 2H2018-type scenario, with EUR IG senior spreads widening by a further 40bp from current levels.

Higher rates are historically not a headwind for credit spreads (in fact they are usually the opposite) but volatility and uncertainty arguably are, and we will experience plenty of uncertainty before the central bank meetings in March and, therefore, European credit is unlikely to tighten ahead of this. Negative total returns will persist during February-April, increasing the possibility of fund outflows during this period.