Credit: This Time Is Different?

Credit market volatility this year has been extreme. The Franklin Templeton Investment Solutions team looks back at history to see what to expect from certain fixed income asset classes, noting that history may not repeat. They also examine the likelihood of recession and its possible severity.

Key Points:

  • Incredible volatility in credit markets: This year has seen significant volatility in credit markets given the tumultuous macroeconomic backdrop and hawkish Federal Reserve (Fed). This period is unique given valuation levels.
  • History not necessarily a playbook: Investment-grade bonds, bank loans, and high yield bonds could perform differently now than in prior risk-off periods due to asset class-specific developments.
  • Recession fears emerging: On top of this, recession fears have been sparked. There are reasons to believe, should the United States enter a recession, it may be mild. While we do not think one is likely in the next 12 months, it is a risk particularly in 2023 and worthy of close attention. For more specifics on inflation, yield-curve inversion, corporate fundamentals and profitability, please read below.

This time is different?

We can begin to include 2022 into the pantheon of very unique periods for the broader credit markets, such as investment grade, high yield, and leveraged loans, along with previous periods such as the global financial crisis (GFC) in 2008 and the global pandemic that started in 2020, where volatility was heightened. Given the macroeconomic backdrop—a war that we haven’t seen the likes of for at least five decades, the world’s second largest economy (China) going through a COVID lockdown once again, and global inflation levels that have also not been seen for at least four decades now—it isn’t hard to understand why.

While the volatility in US credit year-to-date has not been quite as dramatic as both the GFC and the beginning of the COVID-19 pandemic, we really haven’t seen a selloff like this in the broader US fixed income market for quite some time. The selloff is due to the view that the Fed will need to raise interest rates quickly and furiously to rein in inflation by slowing down growth meaningfully, putting the risk of recession on the table.