Navigating post-pandemic markets

The pandemic may be over, but scars remain. Debt accumulated by sovereigns and corporates alike have not dissipated with the pandemic. Expansionary fiscal and monetary policy have lingering effects, contributing to elevated inflation across many economies. As such, they pose challenges to monetary and fiscal credibility, with profound implications for credit markets. Negative market reactions to the overtly hawkish Fed, as well as to the UK’s mini-budget last week, underscore these.

An unambiguously hawkish Fed

One of the most important post-pandemic shifts is the Fed’s policy stance. In its September FOMC meeting, the Fed gave its most hawkish policy guidance in recent memory. Not only were projections of the terminal rate revised higher to near 5%, but Powell’s tone had hardened significantly. He acknowledged for the first time that prospects of a soft landing are diminishing. This may be a tacit admission that inflation had become so entrenched that the Fed could be forced to stay on a tightening path even if growth slows significantly. Faced with a more hawkish Fed stance to restrict growth, US yields have repriced higher across the curve, and credit spreads have also widened across US markets.

In rates, the US 2y, 5y, and 10y yields jumped by between 23-35 bps compared to the previous week. Credit assets were doubly hit by rising rates and higher spreads. The US IG and HY average OAS have widened by 6bps and 12bps respectively post-FOMC. For US IG bonds, spreads are now closing towards their July peaks, which mark a significant tightening of credit conditions given the large proportion of IG bonds in US credit.



Fed’s repercussions on global rates and credit

Given the size and hegemony of US capital markets, soaring US rates have spillovers beyond US borders, intensifying portfolio outflows and currency depreciation for the rest of the world. Post-FOMC, the USD has strengthened even more across the board, with the DXY index rising by 3.1% and Asian currencies (proxied by the ADXY index) falling by 1.8% for the week. The implications of rising rates and a rising USD on EM USD debt servicing are clearly negative.



To mitigate against sustained USD strength and capital outflows, global central banks are under pressure to partially track Fed policy, setting policy tighter than it would otherwise be. Consequently, a concerted wave of rate hikes across both DMs and EMs is now underway, and this global policy tightening trend will continue as long as the Fed pushes rates higher. Markets now expect the ECB and BOE to hike by over 230bps and 350bps respectively over the next 12 months while in Asia, RBI and BoK are also seen by markets to enact over 130bps of rate hikes.

Concerted global rate increases, a reversal of loose liquidity conditions, and a Fed-induced slowdown are set to raise volatility in credit markets. Geopolitics and supply chain disruptions add further to the cocktail of risks. Highly leveraged firms could enter a more difficult environment for refinancing, as soaring interest costs and a coming slowdown in revenues spur a repricing of default risks. This may mark a transition in regime from the previous period of low defaults backstopped by accommodative policy to a new regime with higher default risks due to restrictive policy.

European uncertainty amid Russian aggression

Beyond monetary policy shifts, geopolitical risks have also risen dramatically post-pandemic, with European credit being most exposed. On top of contending with ECB’s upsized rate hikes, European credit investors must also weigh ongoing developments in the Russia-Ukraine war.

Putin had upped the ante with a partial mobilization of 300k reservists, the initiation of referenda for occupied Ukrainian provinces to join Russia, and a thinly veiled threat to use nuclear weapons. Russia embarking on a game of chicken suggests that risks of further escalation are now more likely. There is also a risk of internal turmoil in Russia. For European industries, Russian belligerence raises risks given their dependence on long-term contracts for Russian supply of commodities including aluminium and nickel. The abrupt disruption of gas supply to Europe shows that such supply chain risks can no longer be ignored.

On top of Russia, political uncertainty also swirls in Italy. The country has elected a right-wing government led by the nationalistic Georgia Meloni, leader of Fratelli d’Italia. She had expressed a desire to re-negotiate with Brussels over Next Generation EU funding conditions. Anticipating post-election tensions, Italian-German bond spreads have widened back to 2020 levels, even with a new backstop by way of the ECB’s TPI (or Transmission Protection Instrument). A sharp Italian debt sell-off could reintroduce concerns over debt sustainability, weighing further on European credit.



Amid these risks, European IG and Crossover CDS spreads have widened last week to 130bps and 637bps respectively, and now stand at their highest since early 2020. Spread levels do look attractive, given that historical European default rates had been below 2% since 2014. But prospective ECB rate hikes had already led to a surge in issuance costs to decade highs for French and Italian corporates. This could make refinancing increasingly difficult for zombie firms with earnings that are too low to service debt. Defaults are likely to pick up, and spreads may stay elevated for some time.



EMs’ fiscal trajectories face rising scrutiny

2022 has shown that monetary policy faces limits amid entrenched inflation. 2023 may well show that fiscal policy faces limits too from wary debt investors, as QE ends across most DMs. The recent sharp tumble in Gilts and GBP have shown how sensitive markets have become to blatant disregard for fiscal consolidation. The lesson is a sobering one: If a large, developed economy cannot hand-wave its fiscal responsibility, what are the chances that emerging economies are able to do so? 

Possibly, sovereign debt investors’ scrutiny could increase amid elevated inflation and rising rates, posing a third risk for EM credit markets.



Sovereign 5y CDS spreads for Emerging Asia have been on a rising trend since the start of the year. This is driven by increased concerns of a China-led slowdown, and also fanned by rising US rates and the stronger USD. China and the Philippines have already seen CDS spreads exceeding their pandemic highs. For Indonesia, CDS spreads have been insulated by its strong commodity exports. However, softer commodity prices amid demand destruction could soon pose headwinds.

Rising USD rates and sovereign CDS spreads underscore the need to enhance fiscal credibility going forward for EM Asia. This is particularly so for Indonesia and Philippines, where FX debt have risen and the FX reserve coverage of such debt has fallen below 1.2 times, down from over 1.7 times in 2013. The silver lining is that much of this foreign currency debt has long-term maturity, so short-term external debt remains manageable.



Asian USD credit stays resilient…

Even though USD rates and CDS spreads have risen this year, Asian USD credit have held up well. Our aggregate spread measures for Asian USD credit, the DACS indices, have mostly consolidated at around late 2021 levels.



China’s property credit distress had not resulted in any contagion for the rest of the Chinese credit market, given increased infrastructure stimulus and low non-property NPLs. Adequate policy space for fiscal and monetary support is one factor that is supporting China USD credit, even as most DM credit spreads widen. For India and Indonesia, USD credit spreads have shown more volatility amid USD strength and a hawkish Fed. Still, a recovery in domestic growth has also underpinned sentiment. However, a slowdown in regional growth may again trigger a widening in spreads.

…but local currency credit sees divergence

Local currency credit showed a divergence in performance within Asia. For currencies where rates are more correlated to USD rates, such as the HKD, SGD, and KRW, their local currency corporate bonds have seen negative returns on a year-to-date basis that are between -2.1% to -4.6%. Carry is not sufficient to negate the negative hit from rising rates for such credit.



On the other hand, RMB, INR, and IDR local currency corporate bonds have registered year-to-date gains that range from 2.0% to 3.4%. China onshore RMB credit was helped by declining RMB rates, with the PBoC lowering its MLF and LPR rates to support growth. For INR and IDR credit, higher carry help to limit duration headwinds, while local rates also saw a smaller increase compared to USD rates. New defaults in 2022 are also almost negligible for India and Indonesia, supporting credit returns given their higher spreads compared to more developed Asian peers.



Watchful of policy-markets interplay

In conclusion, hawkish central banks, geopolitical tensions, and EM debt vulnerabilities are hurdles for credit markets to overcome. But this does not imply a finality to outcomes. Policymakers have room to calibrate polices and achieve a balance that will both reinforce credibility and limit distress for corporates amid post-pandemic headwinds.

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Chang Wei Liang

FX & Credit Strategist, Global

[email protected]