Institutional Money (21.01.2022) - For most of the past year, we have been cautious on interest rates and positive on credit. As we look ahead to 2022, we continue to maintain these views.

At the end of 2021, central banks took further steps towards removing the extreme levels of policy support that had been in place since the onset of the pandemic with the Fed doubling its tapering pace and the BoE surprisingly hiking interest rates. Despite Covid cases re-accelerating amid the Omicron wave, central banks chose instead to focus their attention on rising inflation concerns. This suggests that monetary policy is at an inflection point as we head into 2022, with the trajectory of inflation from here set to be a key determinant of whether the market is adequately pricing the tightening to come. Following the impressive vaccine and booster programs that have been implemented globally over the past year, a key question will also be whether the pandemic is at a turning point in 2022, where governments choose not to enforce strict lockdown measures with each new wave of infections. If this were to be the case as we are already seeing with the Omicron wave, then it should allow for supply-side constraints, which have added to inflation fears and weighed on production in 2021, to fade. It would also allow for the growth recovery to continue and the service sector to finally normalise.

We continue to see this macro environment as positive for credit, as we do not anticipate an aggressive tightening in financial conditions as a result of hawkish central banks’ actions. Although we do expect real rates to rise, they are starting from historically depressed levels and so should not be disruptive for risk assets. In addition, with central banks attempting to lift rates for the first time in many years, they are incentivised to do so in a smooth manner and high enough to provide room to cut rates again in a future downturn. We also see this hawkish shift as being driven not only by inflation fears, but also by the more robust global growth backdrop which has been accompanied by tightening labour markets. We expect this growth picture to remain intact despite the pandemic continuing to cloud the outlook. Whilst new variants cannot be ruled out, as we have observed with Omicron, this latest wave has also shown us that vaccines and boosters have done their job in decoupling case growth and fatalities. This reduces the likelihood of governments reintroducing strict lockdown measures and should allow economies to continue to normalise and the service sector to drive the next leg of the recovery. Crucially, such a development should also allow supply-side constraints to begin to improve, as already observed with shipping costs starting to normalise and chip production returning. This, coupled with commodity price stabilisation should also allow headline inflation to moderate through 2022, which should be taken well by risk assets.

We also see this backdrop as positive for credit from the micro perspective, given impressive and improving credit fundamentals following strong earnings growth in 2021 with prudent balance sheet management. For example, net leverage for US investment-grade names has fully reversed the increase observed during the pandemic, whilst a US high-yield default rate of under 1% for 2021 highlights how this segment of the market benefitted from the reopening of economies on the back of the vaccine roll-out. Although there are plenty of concerns around inflation, our own analysis indicates that some inflation, if not too high, is actually good for corporates, where the inflation losers account for only 17% of the European IG credit market.

Taken together, we have a preference for high-beta credit with low duration, favouring subordinated financial debt, in particular AT1s, which should benefit from the rising rates, and high yield given attractive valuations and improved fundamentals.