The macro environment may play an outsized role as investors rationalize their risk tolerance amid interest rate uncertainty. Active managers appear set to showcase risk management and credit selection as value narrows and loss mitigation becomes central. Enter now, the credit picker’s market.
Key takeaways
- Macro environment to play an outsized role.
- Income to drive returns over capital appreciation based on starting yields and spreads.
- Active management to add value as fundamentals disperse and value narrows across markets.
Inflation proved more persistent than consensus expectations, and the yield curve steepened as market participants recalibrated expectations. With the economy keeping credit defaults largely in check, an environment conducive to loan performance emerged and demand surged amidst a spike in collateralized loan obligation (CLO) issuance. Appetite for credit risk remained, while inflation prevented the Fed from lowering rates and thus reducing loan yields.
Looking forward, we expect the macro environment to play an outsized role in credit performance. Over the past few quarters, we’ve maintained our call that inflation will remain stickier than expectations and bind the Fed in a more restrictive monetary posture, even if the economy begins showing signs of weakness. The inflationary impact of geopolitical instability and trade reallocation—as well as the CapEx and energy consumption related to artificial intelligence—remain elevated and unpredictable. At a point yet distant in the future, artificial intelligence accompanied by a more robust and diversified energy grid will likely be heavily deflationary, but the near-term impact is much the opposite. In our view, these factors will drive inflation volatility and prevent the Fed from neatly tucking inflation in at 2%.
As a result, we think credit investors should not expect to receive much help from the Fed this year. Instead, investors should keep an eye toward fundamentals and the possibility that recently emerging trends continue—namely, increasing loan default rates and a bias toward quality. Based on our view that capital appreciation may be immaterial through the end of the year, insulating attractive starting income from credit losses will be key to realizing the coupon-like returns we forecast.
