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April 20, 2020

Chart of the Week: Have credit markets ‘passed the peak’?

by Fathom Consulting.

Over the past month, equity prices have seen a somewhat remarkable performance, rebounding nearly 30% from mid-March lows even as COVID-19 cases and deaths keep mounting, and sobering economic data keep rolling in; perhaps best illustrated by staggering US jobless claims. As we have pointed out several times in our daily Recession Watch  updates, we believe markets are underpricing the risk of a more severe economic downturn with a protracted recovery. The relative optimism in markets is driven in part by aggressive monetary and fiscal stimulus across the developed world; the risk is that this stimulus – especially on the monetary side – is sufficient to placate investors but will not be enough to avert crisis in the real economy.

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An ominous warning of the risks that continue to brew could be credit markets. Buoyed by the Fed’s unprecedented commitment to outright purchases of US corporate debt, including in the riskier, high yield segment of the market, corporate spreads have remained calm relative to other metrics of market turmoil. As we pointed out in a note to clients last year, complacency in corporate debt relative to equity markets has, on several occasions, presaged major credit market events. The sharp freeze on economic activity jeopardising the earnings of an already highly leveraged corporate sector arguably puts credit markets square into the crosshairs of the ongoing COVID-19 crisis. Based on the amount of corporate credit outstanding in the short term, particularly in foreign currency, and therefore at risk of cash-flow crunches, certain European countries appear most at risk. At Fathom, we have held a bearish stance on credit for over a year. We now see the risk that, reassured by the Fed’s monetary splurge, investors are sleepwalking into a nasty downside surprise to unwind their latest cautious optimism.

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