If omicron paradoxically lowers the temperature of the market, that may be no bad thing

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

The global economy is well protected against omicron — and a mild infection may be beneficial

It will take a few weeks before we can really assess the morbidity/mortality associated with the virus’s latest avatar, omicron, but there is good reason to think the credit markets will only suffer mild symptoms.

After more than a decade on a monetary drip, followed by a regime of monetary and fiscal injections, the economy is looking surprisingly robust. Firms are rebuilding depleted inventories, while higher prices are finally encouraging renewed investment in capital stock, the age of which has increased over the last two decades in the US, UK, Eurozone and Japan, with a depressive effect on productivity.

Consumers are sitting on relatively high levels of savings (especially the older/wealthier cohorts, whose pensions, property and financial holdings have been inflated by steroidal monetary policy). Wages too are growing at a healthy (arguably too healthy) clip. The supply-chain sclerosis that was a pernicious side-effect of covid is also beginning to ease.

IG corporates are in rude health

Record profit margins (the result of sedulous cost control in the years of austerity following the financial crisis) allow room for inflation-related erosion without undermining coverage metrics. Leverage has crested and is now declining. In addition, having availed themselves of the need of bond investors to eke out returns by extending duration (the average tenor of US IG bond issuance rose in each of the three prior years to a record 12.5 years in 2020), IG corporates have pushed out maturity cliffs, insulating themselves from potentially rising near-term refinancing costs (or waning investor confidence if omicron spooks the market). Having invested heavily in digitisation and supply chain resilience, they are also equipped to withstand another wave.

Moreover, not merely is the patient in reasonable shape but, if it takes a turn for the worse, we know what the doctor will do. The US treasury could reinstate its Primary and Secondary Market Corporate Credit Facilities, which did so much to restore confidence in the wake of covid’s first assault (even though the Primary Facility was not deployed and only $14bn spent on secondary purchases). Similarly, the US Fed could push out rate guidance and maintain purchases, while there is no reason to doubt further capacity under the European Central Bank’s Pandemic Emergency Purchase Programme.

We might be less confident of fiscal stimuli, but significant amounts have already been committed (and not yet spent) in both the US (Build Back Better) and Europe (Resilience and Recovery Facility), marking a seismic shift in the political mindset from that prevailing pre-pandemic.

Also, it seems reasonable to expect governments to offer additional support to the most beleaguered sectors (airlines, aerospace, etc), since, having propped them up during the first waves, it would make little sense to let them fail in the latest. France has already pledged extra support for its travel sector, if needed.

The problem that the market faced pre-pandemic was less one of fundamentals and more one of valuations. The cyclically-adjusted price-earnings ratio for the US had revisited Roaring Twenties levels, which were surpassed only during the dotcom boom. While IG credit spreads still compensated investors for multiples of historical default risk, credit indices were only a few basis points off post-2008 tights (arguably in line if adjusted for the deterioration in credit quality).

The appearance of omicron has prompted an increase in spread dispersion, with 10th-90th percentile spread up over 20% in a matter of days and median spreads above 60bp for the first time since February. This is a conducive environment for active managers, who can take positions in favoured IG names that have been beaten up and access the potential tsunami of rising star credits (whose ascent omicron may delay but is unlikely to disrupt) more cheaply than was possible only a fortnight ago.

If omicron paradoxically lowers the temperature of the market, that may be no bad thing.

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Global credit funds & CLO's

January 2022 | Issue 241

Published in London & New York.