The past has been positive. Credit investors have generally had a solid run in the past 18 months. According to our calculations, investment grade and high yield credit generated positive returns through 2023 and 2024 year to date (up to mid-August), with Asia credit performing the best against its US and European counterparts.
It wasn’t just investors that had it good with higher for longer interest rates driving income and total returns. Issuers also found a somewhat conducive environment for primary issuance with historically tight credit spreads.
The Bloomberg Asia USD IG Index average option-adjusted spread reached a new all-time low of 76 basis points (bps) in late May, while the Bloomberg Asia USD HY Index average option-adjusted spread reached 467 bps on July 22, its lowest amount since July 2020, during the pandemic-era-induced spread tightening caused by the US Federal Reserve’s policy responses to normalise credit markets following a period of severe dislocation.
However, the start of August saw credit markets wobble. Asiadollar (excluding Japan and Australia) primary market issuance slowed ahead of the July FOMC meeting while credit spreads widened. At the same time, various Asian equity markets opened the first full week of August in the red, with percentage falls at historical highs.
The sudden correction in credit markets followed a confluence of factors, including soft US jobs data released at the start of August, reigniting fears of a US recession and market concerns of a potential emergency rate cut. Additionally, the continued strength of the Japanese yen was seen to weigh on earnings growth for Japanese banks and exporters and affect the pricing of financial assets outside of Japan. Escalating tensions in the Middle East also added to a flight to safety.
These temporal influences may not have been the only factors at play. In June, facing rich asset valuations and somewhat benign market volatility, we looked at the majority of external risks as disclosed in various Financial Stability Reports published globally in 1H2024 and late 2023 to answer the uncomfortable question of “What could go wrong?” after a time when things seemed to be going too right.
Declining debt servicing ability
Higher interest rates for longer periods put pressure on corporate and household balance sheets. Liquidity and buffers for managing unanticipated income shocks and financing costs are declining.
The problem is not yet widespread, with adequate cash buffers built through the pandemic to offset the rising credit impacts from higher funding costs, lower economic growth and certain policy measures to restrict overleveraging.
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Still, pressure is building for highly leveraged corporates and vulnerable households, especially those with refinancing coming due. The Hong Kong Monetary Authority’s Half Yearly Monetary and Financial Stability Report March 2024 highlighted signs of cash buffer depletion and expectations that more corporates in Asia could face repayment difficulties if operating conditions remain weak while interest rates remain high.
The International Monetary Fund’s (IMF) April 2024 Global Financial Stability Report also highlighted the erosion of cash liquidity buffers for firms in advanced economies and emerging markets over 2023 as corporate earnings appear to be losing momentum.
According to the IMF’s report, around one-third of small firms in advanced economies had a cash-to-interest-expense ratio below 1 at the end of the third quarter of 2023, while that number rose to more than half in emerging markets. At the same time, a large amount of corporate debt is maturing globally in the coming year at higher funding costs. Some of this could be refinanced by private credit instead of commercial banks and public debt markets.
Credit demand may fall as debt servicing ability declines and operating conditions could soften. This will impact profitability and liquidity risks and increase financial institutions’ rising deposit and wholesale funding costs.
This may lead to higher longer funding costs for the economy. The impact may not be so much a concern for larger domestic systemically important financial institutions but more important for non-bank financial institutions (NBFI) whose participation in financial markets has grown in recent years and have opaque and higher risk exposures than larger domestic systemically important financial institutions.
The US Federal Reserve’s April 2024 Financial Stability Report highlighted how tighter financing conditions could amplify loan losses, further tightening financing conditions and creating a downward spiral in confidence.
Similarly, the IMF drew a connection between the high average correlation and multiyear low volatility across equities, bonds, credit and commodity indices in advanced economies and emerging markets and the high susceptibility of investor sentiment to abrupt changes in data releases. This could prompt a sharp tightening in financial conditions. Existing weaker asset classes, such as commercial real estate, would be most exposed, especially where refinancing is imminent.
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Geopolitical risks
Despite the prospect of tighter financing conditions, regulators consistently note that the risk of recession and a hard landing has diminished. However, overall risks are still tilted to the downside, largely due to increasing geopolitical tensions.
We believe these have increased the impact of “unknown unknowns” on global credit markets. The Reserve Bank of Australia highlighted the negative impact of a severe adverse geopolitical event in its March 2024 Financial Stability Review as being amplified given the current expectations of a soft landing, the low-risk premium and volatility across asset classes and their interplay with financing conditions.
An unanticipated outcome combined with fragile market functioning could be one reason for a disorderly adjustment in financial asset prices leading to a hard landing, particularly where shortcomings in leverage and liquidity mismatch management exist, including by non-bank financial intermediaries in key financial centres.
These views are shared globally. The European Central Bank’s (ECB) May 2024 Financial Stability Review highlighted that the current benign pricing of risk in financial markets keeps asset prices vulnerable to shocks and raises underlying vulnerabilities to financial stability. This is especially true where the perception of low risks has led to excessive risk-taking.
The US Federal Reserve’s April 2024 Financial Stability Review identified stretched asset valuations as one of four financial system vulnerabilities. Any worsening global geopolitical tensions would disrupt energy and commodity markets and global value chains, boost inflation, reduce economic activity and heighten financial market volatility and asset repricing.
Recent geopolitical pressures have also increased the risk of policy uncertainty, including trade and other foreign policy issues, which may accelerate ahead of the upcoming US elections in November.
Finally, while a soft landing is the IMF’s base case in their April 2024 Global Financial Stability Report, the IMF also identified the current environment as one with stretched valuations in various asset classes. Asset repricing could happen quickly from sudden policy shifts or a flare-up of geopolitical tensions, sharply tightening financial conditions. The synchronised upward movement, low volatility in asset valuations and high susceptibility to abrupt changes in investor sentiments are among the IMF’s “financial fragilities along the last mile of disinflation.”
Recent Financial Stability Reports published globally have shown that underlying sensitivity remains high and financial conditions can tighten rapidly. Weaker asset classes and credit issuers remain most vulnerable to this dynamic, particularly those with higher refinancing needs. Investors should continue vigilance in this period of temporal and persistent risks.
As UBS Group AG CEO Sergio Ermotti mentioned during interviews around the release of the bank’s second-quarter results, investors should heed last week’s global selloff as a sign of “fragility in the system.”
Andrew Wong, Ezien Hoo, Wong Hong Wei and Chin Meng Tee are credit research analysts with OCBC’s Global Markets Research team
