TwentyFour Asset Management
A lot has been made of the recent recovery in equity markets, especially in the US, given the obvious underlying weaknesses in the economy. It is quite clear to us the economic fundamentals do not justify such high valuations in risk assets, but despite being a serious consideration in our assessment, there is often much more to valuations than just fundamentals.
Do not panic, I am not about to give an equity market analysis, so let’s focus on risk markets more broadly, and in fixed income that means credit.
Credit spreads overshot to the downside in March, with precipitous falls on a mark-to-market basis as investors sold assets regardless of quality in their desire to reclaim cash. April saw a recovery that appeared far more orderly and risk-conscious.
As we stand today, we see the credit markets probably approaching fair value given the overall backdrop, though historically they still look cheap, and we think this rally is justified despite the appalling fundamentals in front of us.
Before trying to rationalise this view, it is worth looking at how higher quality credit has led the recovery. By way of example I will use the US market as it is here that most of the unjustified equity market rally allegations have been aimed.
Below is a table looking at the spread developments this year over the ‘risk-free’ rate for US credit, covering the investment grade, high yield and CCC indices. The rally has clearly been more pronounced in the higher rated indices than in the CCC bracket, which we know historically is where the vast majority of defaults occur.
|Index||2020 Low Spread||2020 High Spread||Current Spread||Retracement|
There are four principal reasons we believe this bounce back in spreads is justified, and in fact likely to continue, though this will almost certainly not occur in a straight line:
As we have mentioned on several occasions already, we don’t think this is the time to be adding the lower parts of the risk spectrum, as it is here that the major vulnerabilities lie. It is a fair assumption in our view that less than 50% of those companies in the CCC ratings band today will be around in five years’ time, in their current form at least.
It is still a good time to focus on quality, however, and the rally is completely justified by non- fundamental factors. These technically driven rallies can be quite painful for those underinvested or short, and this is no exception.