As we head towards the completion of Rishi Sunak’s first 100 days as UK Prime Minister, it is worth reflecting on how sterling credit markets have fared since the end of the disastrous and short-lived Truss Premiership.
The answer is that markets have performed extremely well. Since Liz Truss resigned on 20 October, sterling investment grade bonds have returned 8.8%*, aided by a material recovery in the gilt market (10-year gilt yields are lower by around 60 bps over this period) and an even more impressive compression in investment-grade spreads.
This happened for a combination of reasons – falling inflation; renewed domestic fiscal credibility; lower expectations of gilt supply; an easing of concerns about how much central banks will tighten; and an acknowledgment that sterling investment grade valuations had reached extremes.
We have to say, we weren’t surprised by the recovery, as we set-out in our 17 October article titled ‘Why investment grade credit is looking attractive’. What happens now is much tricker.
So, what might investors expect from investment grade credit over the remainder of the year?
Let’s start with the Bank of England and the likely path of rates this year. Current market expectations are for base rates to peak at close to 4.5% at some point in Q3 (the current rate is 3.5%). While retail figures for the festive period beat the dire expectations, it would be a stretch to describe the UK consumer as being in rude health.
We expect inflation to continue to moderate, particularly aided by lower energy prices. We also believe the Bank of England will ultimately fall short of market expectations around rate rises. We would not be surprised to see the Bank’s prevailing rhetoric err on the hawkish side in the interim, as it wrestles with a desire to regain credibility. Ultimately though, delivering four further hikes before the end of Q3 of 2023 will be a challenge.
Sterling credit spreads reached a wide point of 250 bps in mid-October and have since retraced around 80 bps, reaching an aggregate level not seen since June 2022. While the ‘easy’ money has undoubtedly been made, aggregate (index) spread levels are still at reasonably elevated levels compared to where they have been over the past 10 years. The all-in-yield figures are just as compelling, with a current yield-to-maturity of more than 5%. By way of context, this figure was closer to 2% at the start of 2022 and 1.4% at the end of 2020, albeit we are clearly operating under a different monetary policy regime now.
The global economic backdrop has deteriorated in recent months. The consequence seems to be greater confidence that central banks are now willing to countenance the notion that the worst of inflation may be behind us. This should allow some further – perhaps modest – tightening of credit spreads.
If our assumptions around the likely path of interest rates and credit are broadly correct, then a mid-single-digit total return for the remainder of 2023 would not be a surprise.
* Source: Bloomberg. Markit iBoxx £ Collateralised and Corporates Index. Total return from 20 October 2022 to 17 January 2023 (GBP)
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