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Inflation, a real concern for the credit market? | Opinion

When this last quarter of the year began, our vision was that the economic recovery would allow central banks to start moving towards less accommodative monetary policies, and this could provide room for a rise in interest rates.

That was particularly evident on the short end of the U.S. interest rate curve, with market pricing well behind the Fed’s own projections (dot plot). This defensive view of duration remains intact and has been supported by rising inflation. Although we ultimately foresee inflation to be contained in the medium term, the changes in consumer behavior that we have seen since the onset of the pandemic are unlikely to reverse overnight, potentially keeping the necks of short-term bottle.

We continue to view the macroeconomic context as a positive environment for credit markets, since, although central banks are reducing their stimulus measures, we continue to expect that their actions will be gradual and that, therefore, there will not be an aggressive tightening of financial conditions. This could allow investors to focus on credit fundamentals, which have improved in light of strong corporate earnings and prudent balance sheet management.

We also emphasize that modest inflationary pressures can be really good for companies, as our analysis indicates that more than 80% of the Investment Grade market in euros should see a neutral or positive impact from inflation. One of the biggest beneficiaries of this high interest rate environment will be the financial sector, and we continue to consider that subordinated financial debt, particularly AT1 and high yield, is attractive given current valuations and strong fundamentals.

Examining the recent dynamics of inflation in more detail, we see that the recent upward movement in prices is a consequence of the behavior change due to the pandemic, which has caused changes in consumption and created bottlenecks. For example, since the pandemic began, demand for Asian products has increased, leading to an imbalance in global exports and increased transportation costs. This change in behavior is still in play, given that mobility is lower than before the pandemic despite the reduction in fears of Covid-19, and that also seems to be a reason why the labor market has not yet recovered. completely, despite continued demand for workers.

Looking ahead, we see consumer behavior as the key to determining how long above-target inflation will last. If, for example, consumer behavior returns to the same as before the pandemic in the coming months, we would also expect inflation to return to more normal levels. This is clearly the view shared by the Federal Reserve and the ECB according to their latest forecasts.

However, if these changes in behavior and demand are more permanent, the necessary capacity will have to be built to cope with them. If, for example, we look at semiconductors, estimates suggest that it would take about two years to create the necessary capacity to meet the needs of demand. Once built, this capacity should ease price pressures and allow inflation to remain contained in the medium term.

We also believe that it is important to note that the modest inflationary pressures can be considered really positive. As mentioned above, only a small part of the euro investment grade credit market will see a negative impact from inflation. The sectors that will be affected are the most vulnerable to rising raw material, energy and labor costs.

Instead, however, we expect bank profitability to benefit from higher interest rates, and oil and gas producers to benefit from higher energy prices. For sovereign countries, inflation comes at a time when budget deficits have increased due to welfare benefits provided during the pandemic, so inflation could help cushion these deficits.

For central banks, we believe that inflation gives them the opportunity to finally raise interest rates away from the lower limit of 0%. This is crucial as it will provide them with ammunition later on to cut rates again when the next recession hits, providing another tool of monetary support beyond stimulus. Although the risks of inflation have increased, the reaction of policy makers to it has also changed; For example, the Fed’s median inflation targeting framework provides them with the flexibility not to aggressively tighten policy, even though the core CPI is above target. This is in stark contrast to what we have seen during previous inflationary episodes and should be seen as a source of comfort for the markets.

In summary, although inflation fears have clearly increased in recent times, we anticipate that prices will be contained in the medium term and that modest inflationary pressures in the interim could be positive for credit markets. Therefore, we remain positive on credit, with a preference for subordinated financial debt and high yield, while we see room for interest rates to rise, especially at the front of the curves, as central banks have passed the stimulus peak.

Philippe Graüb is a director of global fixed income at UBP

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