By Simon Gauci Borda
In recent weeks, the world’s largest economies have revised their economic growth forecasts upwards in light of the perceived improvement in economic conditions. The continued rollout of the vaccine, together with the removal of lockdown restrictions which were implemented to contain the spread of the virus, have undeniably had a positive effect on business and economic conditions. Central banks have continued to support their respective economies through their accommodative monetary policies. Policy rates were left unchanged at their historically low levels, while asset purchase programmes continue to be pursued with a reduction in purchases or an increase in rates not expected to be considered in the near-term.
With inflation being one of the key data points closely monitored by central banks, it comes as no surprise that the rise in inflation in recent weeks has been one of the main talking points within financial circles. Core inflation, which excludes energy, food, alcohol and tobacco prices that tend to be volatile in nature, has been on an upward trend in the U.S. as of late, while the Euro Area has experienced the opposite effect. Core inflation rate in the U.S. increased to 3% in April, surpassing both expectations of 2.3% and the March figure of 1.6%. However, the core inflation rate in the Euro Area declined to 0.7% in April falling short of consensus estimates of 0.8% and the previous month’s figure of 0.9%.
The stronger reflationary dynamics in the U.S. has resulted in diverging expectations on central bank policy in the U.S. versus Europe going forward. The Federal Reserve is expected to scale down monetary support to the American economy sooner than the ECB. In fact, the Fed has indicted that it will ease its support to the American sooner than the European Central Bank. While the Federal Reserve has indicated that it might begin discussing the possibility of tapering its asset purchase programmes, which currently stand at $120 billion per month, given the rise in inflation and improvement in economic conditions, the European Central Bank has stated that it might be too early to start discussing such a possibility.
However, while the two economies may be at different stages of their economic recovery, credit rating agencies have revised their default rate forecasts downwards. In fact, Fitch recently revised its European high yield bond default rate to 2% from 5% whilst also revising the expected default rate for U.S. high yield bonds to 2% from 3.5%. Fitch also expects that the default rate for U.S. high yield bonds could decline between 1%-2% by the end of this year. The rating agency also cited an improvement in liquidity, a low number of near-term maturities and continued government stimulus as the main reasons to lower expected default rates.
Corporate credit markets have reacted positively to the publication of positive economic data published in recent weeks, with yields declining and credit spreads compressing against benchmark rates. The U.S. Treasury has stabilised at the 1.60% level while the Bund currently stands at circa negative 0.16%, both substantially higher than the levels seen this time last year. On the other hand, corporate credit yields have declined considerably following the market sell-off last year. European and U.S. high yield debt is currently trading at spreads slightly below 300bps.
The economic recovery is at a critical juncture. We are now at a point where the strong expectations, which have been built up as a consequence of the vaccine progress, need to be validated by improving economic conditions that materialised through the continuation of positive data releases. Corporate credit spreads are expected to remain supported by a sustained economic recovery. However, the economic recovery remains fragile at this stage, and highly vulnerable to an unexpected downturn, possibly brought about by another wave of virus contagion and subsequent lockdowns. Secondly, while government and central banks provided an unprecedented level of support during the pandemic, it is yet to be seen how markets will react once such measures are eventually withdrawn.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.