Strong growth is not necessary for good loan or bond performance, but it keeps a recession at bay

Randy Schwimmer

Co-head of senior lending Churchill Asset Management

The picture in credit was looking good (even with inflation rising) until Russia invaded Ukraine

It was almost a clean getaway. Two years since it emerged, covid was crumbling. The combination of vaccinations and infection immunity were finally having an effect. Across the nation school children are once again seeing each other’s faces. Most businesses are instituting some form of back-to-the-office programme and business travel is picking up.

Inflation was on the rise, but the Fed pivoted in November to a decidedly hawkish stance with rate hikes beginning in March. The economy remained in growth mode across many industries, and job statistics were on a buoyant path. Then on 24 February Russia invaded Ukraine.

Everything has changed in the geopolitical sphere, but it’s too early to tell how this plays out economically or in the capital markets.

As was the case in March 2020, investors and managers took stock. On checklists are sanctions (what knock-on effects will hurt our businesses?), labour (how will workers in the region be impacted?), and regulations (what new rules could international agencies impose?).

Unlike covid-19, which quickly encompassed everyone on the planet, the war in eastern Europe is grinding on regionally to an uncertain outcome. Meanwhile market observers are scrutinising incoming economic data. They present a mixed picture: corporate earnings growth is solid, but cost headwinds from remnant covid shortages remain. Will those flare in coming months if Ukraine uncertainty mounts?

Proximity dictates investor impact

Investors of all stripes are settling on the view that the conflict will stay within certain bounds, and that any economic impact will be more local than widespread. As the head of equities for a top European asset manager says: “You can draw a correlation map between proximity to the conflict and market impact.”

Credit investors are more focused on how the Fed followed up the 25 basis point rate hike with more hawkish commentary from chair Jerome Powell. Perhaps in response to St Louis Fed president Jim Bullard’s lone dissent, where he voiced the need for a more aggressive posture, Powell said: “If we think it’s appropriate to raise [by a half a point]… we will do so.”

At the same time, observers have noted further flattening of the treasury yield curve, with two-year rates edging up in response to Powell’s statement. That trend has raised concerns in some quarters of an inverted yield curve and the signal that historically sends for a slowdown ahead.

The US economy is in good shape

As one investment strategist pointed out in a recent note, the US economy is hardly stumbling. Housing starts and permits are up smartly, manufacturing production is on the rise, and GDP estimates remain ahead of most (non-covid rebound) years in recent memory.

That mix is constructive for credit. Though strong growth is not necessary for good loan or bond performance, keeping a recession at bay is helpful.

High yield bond issuance, which stalled in February and March, has shown few signs of life. Retail funds have lost more than $20 billion this year, as the threat of higher rates sapped investor interest in fixed income. Year-to-date junk bond issuance has totalled $37 billion, down sharply from last year’s $132 billion.

Leveraged loans have been more productive. While overall volume is down about 30% year-over-year ($132 billion versus $186 billion), M&A-related financings rose 22% to $82 billion from $67 billion.

In the private credit market, M&A flow softened from its torrid 4Q 2021 pace. Quality also took a hit. When stock indices fell in late February, bankers worried about a chilling effect on private valuations. As one partner told us: “Why launch into this market if you don’t have to?”

But with public equities recovering, so did expectations for more robust private deal pipelines. “It’s been a slow start to the year,” a direct lender reported. “But our sponsors are predicting a pick-up for the second quarter. Now we just need no more bad surprises.”

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