Credit Outlook: A rebuild of risk premia

Key takeaways

1Q2023 was a quarter defined by three distinct phases: 1) a sharp risk rally in January, 2) reignited concerns around elevated inflation in February, and 3) a focus on risks in the banking system in March.

For 2Q2023, we expect the backdrop for investing will remain volatile, as central banks navigate a challenging growth/inflation/policy mix, now with an overhang of financial stability concerns. We expect an exacerbation of the pattern of tighter credit standards (which has already been in place for the past few quarters in the U.S. and Europe).

This poses downside risks to the economy, although the magnitude of the negative growth impulse is highly uncertain at this juncture. Persistently elevated services inflation leaves rate cuts in the U.S. and in Europe as unlikely this year, in our base case.

Against a backdrop of downside risks to economic growth, defaults remain top of mind. In the public credit markets, we see scope for default rates to increase from historically low levels. But we do not expect a return to the peaks seen in the global financial crisis or the height of the COVID-19 pandemic.

This backdrop warrants a rebuild of risk premia across a wide range of asset classes. From an asset allocation perspective, we continue to prefer credit over equities. Within liquid credit, we look to take advantage of the inverted yield curve, favoring short duration and floating rate exposures while looking for tactical opportunities to add alpha. In private credit, we see structural tailwinds for the asset class in response to the expected contraction in bank lending. In particular, we expect the addressable market to expand and pricing power to be enhanced (reflective of the certainty of execution that private credit provides).