Barclays Warns of Credit Pain in Return to 1970s Inflation Regime

Olivia Raimonde
Tue, August 16, 2022



(Bloomberg) -- Rising prices amid a US economic slowdown will menace embattled credit markets, if history repeats.

The current inflation and growth environment is most akin to the 1973 to 1975 and 1978 to 1980 time periods, when credit markets did badly, according to Barclays Plc. strategists led by Dominique Toublan.

“Credit performance was poor then, and we do not expect this time to be different,” the strategists wrote in a note dated Aug. 12. The asset class “could experience even more pain if the current stagflationary backdrop develops into a deflationary one.”

Through the 1970s periods of rising inflation and weak growth, monthly high-grade credit excess returns were negative 14 basis points on average. Monthly performance was negative 58% of the time, about 15% higher than the long-term average, the strategists wrote.

Credit markets have been battered this year, particularly high-grade, as Treasury yields surged and the Federal Reserve boosted rates to tackle inflation. Despite a July rally -- which marked the best monthly return in two years -- investment-grade bonds are down almost 12% for 2022 so far, according to Bloomberg index data.

Bonds issued by technology companies, banks and basic industry sectors outperformed through inflationary years in both investment-grade and high-yield, according to Barclays. High-grade energy and junk-rated insurance debt also fared better.

During periods of stagflation, insurance, communications and consumer cyclical sectors underperformed, the strategists wrote.

“Stagflationary environments have not been kind to credit, with returns being negative on average when the growth backdrop deteriorates,” the strategists wrote.

Credit investors should be wary of stagflation or significantly slower growth, according to Terence Wheat, co-head of investment-grade corporate bonds at PGIM Fixed Income. He expects high-grade spreads to tighten from current levels before widening out by year-end as the US economy slows.

The spread on the benchmark high-grade index tightened to 131 basis points on Monday, off the 2022 peak of 160 basis points struck on July 5.

“There is still a probability of a deeper recession coming, so we have to be wary of that,” Wheat said.

There is, however, evidence that the worst of inflation may be over, according to David Norris, head of US credit at TwentyFour Asset Management. “The discussions on inflation is what’s going to drive performance,” he said. “There are very good arguments to suggest it has reached its peak.”

Norris expects investment-grade debt to perform better in the fourth quarter. He views spreads at 150 basis points to 160 basis points as good entry points.