The Outlook for Credit Is Increasingly Bleak, Deutsche Bank Strategists Says

(Bloomberg) -- The long-term outlook for credit is getting increasingly bleak as a recession looms in the U.S., according to Deutsche Bank AG's research arm.

Corporate bonds have staged a comeback since a torrid first quarter, when a hawkish pivot by central banks to combat soaring inflation and Russia's invasion of Ukraine roiled markets. While spreads may manage to end the year mostly in line with current levels, the real pain is likely to come in 2023, according to Jim Reid, Deutsche Bank's head of thematic research, and strategist Karthik Nagalingam.

“The cycle seems to be accelerating even more rapidly than we expected and a U.S. recession around the turn of 2023/2024 now seems hard to avoid,” they wrote in a note dated April 5. “Perhaps the wider starting point for spreads given the recent sell-off gives us a few months of calm before the storm but at this stage we would certainly want to be short credit in 2023.”

Reid and Nagalingam see credit premiums for dollar and euro high-yield bonds more than doubling to 850 basis points by the end of next year.

Late last month the U.S. two-year yield briefly exceeded the 10-year for the first time since 2019, which is seen as a harbinger of recession. Money-market traders are betting on the steepest Fed tightening in almost three decades after Tuesday's hawkish comments from Governor Lael Brainard.

Yield Curve Inversion Is Bad News for Credit, Barclays Says

While Europe is behind the U.S. in this cycle, another sustained spike in energy prices could push Europe into a recession first, according to Reid and Nagalingam.

They have raised year-end 2022 spread forecasts slightly from prior levels, given the souring economic outlook and the tail risk posed to energy prices by the war in Ukraine. Oil prices surged by a third in the first quarter, with the U.K. and Washington moving to bar Russian crude in retaliation.

“However, the reason we aren't outright bearish is that growth should still be OK in 2022. The first year of a rate hiking cycle has also never been where a recession hits,” Reid and Nagalingam wrote.