Why Investors Can Ignore The Inflation Bogeyman

Exhibit 6: North America Credit Transitions

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Source: Credit Benchmark, Credit Capital Advisory

During 2018/19 there was a tendency for investment-grade names to see a higher number of downgrades to upgrades, while there was a tendency for high yield names to show more upgrades to downgrades. The period between Q2-Q4 2020 shows that the rate of downgrades to upgrades was nearly 3 times higher for a rated obligors, rising to nearly 4 times higher for bbb obligors. Crucially, bb obligors have shown a dramatic level of downgrades compared to “normal conditions” and only minimal upgrade to b. The main reason why b rated obligors are positive is that there is a tendency for banks to churn lower quality names from their portfolios, which by definition results in a slight upward bias in transitions. The upshot of this significant increase in downward transitions will be higher defaults, impacting bond yields and equities in affected sectors.

Interestingly though, the credit risk aggregates from Credit Benchmark suggest that the U.S. bank sector can be expected to absorb these losses, demonstrating almost no change in credit risk since the start of the crisis. However, the aggregates also show that U.S. Industrials and U.S. consumer goods have seen a widening in credit risk of more than 20% since the start of the crisis, indicating many firms are struggling with their debt liabilities.

Exhibit 7: U.S. credit risk aggregates

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Source: Credit Benchmark

While investors can be more confident that inflation is unlikely to return to levels observed in the 1970s, this does not mean that all sectors of the market will perform equally as well given the rising expected defaults in sectors affected by the pandemic. Expected profit growth remains uneven, which may well impact relative performance.

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