An association of fund managers has issued a grim prediction on the rising risk of credit defaults, warning that central bank interest rate hikes will trigger a wave of corporate defaults as borrowing costs soar and the threat of a global recession looms.
Not a single member of the International Association of Credit Portfolio Managers (IACPM) expressed the view that corporate defaults would decline, according to the group’s latest quarterly survey released on July 14.
“On the contrary, an overwhelming majority believe that delinquencies will increase in North America, Europe, Asia and Australia,” the IACPM said in a statement.
The survey was conducted among members of the association, which include portfolio managers from several of the world’s largest commercial banks, investment banks and insurance companies.
The association’s latest credit default outlook score came in at minus 82.3, a sharp drop from minus 58.0 in the previous quarter, which in turn was well below the positive 2.6. recorded nine months earlier. Positive numbers reflect expectations of improving credit conditions, while negative numbers suggest belief in a coming squeeze.
“Looking at these results, it is almost impossible not to think that the risk of recession is extremely high virtually everywhere in the world,” said Som-lok Leung, executive director of the IACPM, in a statement.
“In financial markets and among our members, there is a growing view that the US Federal Reserve will have to induce a recession to bring rising inflation under control,” he added.
Europe is in a worse position than the United States, where consumers and businesses have substantial liquidity and defaults are at historic lows, the IACPM said. Still, America is far from immune to default risk, Leung noted.
“Defaults are currently at rock bottom, but that will change over the course of the year,” Leung said. “Consumers and businesses have some cushion at the moment, but our members expect to see a significantly higher number of defaults in 2023 and possibly even 2024.”
The Fed’s fight against inflation
The Fed is struggling to control soaring US inflation, which hit a new 41-year high of 9.1% in June.
The central bank has also expressed concern about a rise in future inflation expectations, which threatens to become a self-fulfilling prophecy and further amplify inflation if left unchecked. Inflation expectations for the coming year in the United States have reached record highs.
Median one-year inflation expectations rose from 6.6% in May to 6.8% in June, marking another record streak, according to a recent survey by the New York Federal Reserve.
The Fed embarked on a cycle of monetary tightening in an effort to ease strong price pressures, raising rates at its latest policy meeting by 75 basis points to a target range of 1.50 to 1, 75%.
Data showing a slight rise in the inflation rate when the figures were released earlier in the week sparked strong speculation that the Fed might become more aggressive in its fight against inflation.
Economists and traders are now more or less evenly split in their expectations of a 75 basis point hike and a 100 basis point hike in the benchmark rate when Fed officials meet in late July.
Fed funds futures show a 51.3% probability for a 0.75 percentage point rise, while placing the probability of a 1.00 percentage point rise at 48.7%, according to the CME FedWatch Tool, at the time of writing the report.
As nations around the world turn to tighter monetary policy to rein in high inflation, the IACPM said survey respondents widely noted that rate hikes are a “blunt instrument” that carries a “serious risk of overcorrection”.
“The monetary policy risk is well known and entrenched at this stage, as is the lingering risk of inflation and the threat of recession,” Leung said.
“The risk is high and it’s everywhere.”
Uncertainty drives investors to reduce risk
Growing concerns about a possible recession are prompting some investors to reduce risk in their credit exposure.
As rising interest rates add pressure on credit, some investors are looking to reduce their exposure to lower-rated credits and look to corporate bonds that are likely to be more resilient in a downturn.
“We will still hold high yield, we will still hold some emerging markets, but I think we probably want to hold less going forward in the next three to six months,” said Nick Hayes, head of global strategic fixed income strategy. at AXA. Investment Managers, told Reuters.
“We want to improve the quality of the whole portfolio because we may be heading into a really uncertain period,” he added.
But higher interest rates are likely to reduce supply, posing a challenge for bond traders looking to spread their exposure between secondary and primary markets, traders told Reuters.
Earlier in July, high-yield spreads hit a two-year high of around 600 basis points as Bank of America strategists told Reuters the Fed never raised rates when credit conditions were also tight.
Yet high yield spreads do not show the stress levels associated with some past crises.
Spreads widened to over 2,000 basis points during the 2008 financial crisis and to over 1,000 basis points in early 2020 at the onset of the pandemic.