Has spring sprung for sterling credit?

Sterling credit spreads have staged something of a recovery of late. We believe this is overdone, given the gathering clouds on the macro horizon, raising the prospect of fresh buying opportunities over the coming months.

In March, wage and price inflation in the UK both came in higher than expectations. At 6.6% and 10.1% respectively, there would appear to be little sign of an imminent pause in monetary tightening. Indeed, interest rates are now widely expected to increase by 25bps at the next Bank of England Monetary Policy Committee meeting on May 11, with the market pricing two more hikes before peaking in September. 

Unsurprisingly, yields have increased at the short end of the gilt curve in response. Two-year gilt yields are at 3[1] having climbed around 20bps year-to-date after troughing as low as 2.80% at the end of January.

Both two- and ten-year yields have been volatile in response to both the mini banking crisis in early March and recent strong data releases. Our macro view remains that the lagging impact of monetary tightening and the likelihood of rates remaining higher for longer in the developed world means recession and earnings pressure will be very hard to avoid as we enter the second half of 2023.

Bank woes

While banking sector stress via Silicon Valley Bank* and First Republic continue to take centre stage, it is a very different industry in the UK and Europe, with a much less fragmented regional structure.

Indeed, [2]; 565 have failed this century. Bank failures are thus not rare, but it is notable that there had had been none between 2020 and this year.

While banks are ultimately cyclical credits that will suffer write-offs, ahead of the recession we expect, they are much better capitalised and regulated than they were before 2008. Recent signals from the Bank of England around potential increases to deposit insurance would be a positive. We remain overweight banks, enjoying the yield but ever conscious of their need to issue.

Spread outlook

All of this this leads us to believe that the recent recovery in sterling credit spreads is overdone. We believe it has been driven by the ongoing attraction of higher yields and attractive cross-currency valuations creating a strong technical demand backdrop, supported by a limited supply. The Bank of England is around 70% through their unwind of the corporate bond-buying programme, and is well ahead of schedule to finish the process by their year-end target.

While this dynamic is set to have further to run in the short term, we do not believe it is sustainable as the impact of both eroding real incomes and the exhaustion of consumer savings becomes clear. 

As a result, we remain comfortable with our underweight positioning in all cyclical non-financials, with the notable exception of utilities. The total returns of the asset class should be supported via falling yields as recession looms ever larger, but credit spreads would logically widen. We intend to use this as a buying opportunity to scale into favoured sectors and names.

 

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[1] Source: Bloomberg

[2] FDIC