As we approach the beginning of the fourth quarter, market conditions look eerily similar to those which preceded the third quarter. Despite recent volatility, equity returns have been strong over Q3 and valuations, measured by forward P/E ratios, are even higher than the lofty levels from a quarter before. Credit markets followed suit, with returns and spread tightening exceeding our somewhat optimistic Q3 expectations across both high yield bonds and senior secured loans. GDP growth, expected to be strong once Q3 data is released, reflects the solid momentum that built toward the end of an abysmal, pandemic-induced Q2. Meanwhile, the path of the global battle against COVID-19 remains somewhat uncertain, with optimism surrounding a vaccine offsetting stubbornly high but stable cases in the U.S. and a resurgence in parts of Europe.
- Market conditions entering Q4 resemble those of Q3, despite recent equity volatility. We expect to see strong Q3 GDP growth which, along with a supportive Fed and optimism surrounding a vaccine, provides a solid backdrop for credit markets.
- While we maintain a favorable outlook, we think the well above average returns from Q3 are unlikely to be repeated. As the broad beta rally slows, we believe active managers will find opportunity in the dispersion that remains across asset classes, industries and ratings categories.
- Uncertainties do remain. The high-level impact on markets from the looming U.S. presidential election is difficult to predict, but there may be more tangible opportunities for active investors at an industry level.
We believe that against this backdrop, the outlook for credit markets in Q4 remains positive. While uncertainty is still top of mind for many investors, relative valuations across markets support a continued tightening in credit spreads and opportunities for active credit investors. Like we wrote three months ago, if forward P/E ratios for equities are at or near their 100th percentile, why should credit markets still be below their 50th percentile? We believe that an additional 50 bps of spread tightening for high yield bonds and loans, which would take credit markets to their 55th and 60th percentiles, respectively, is reasonable in this environment. On a return basis, this scenario would generate quarterly returns of roughly 3.3% for high yield and 2.6% for loans, or approximately double the historical average quarterly return for both markets.
While we maintain a favorable outlook, we do think that the well above average returns likely to be experienced as Q3 draws to a close are unlikely to be repeated in Q4. We believe the broad beta rally across credit markets that propelled returns in Q2 and Q3 is likely to slow. Managers may need to become more selective, taking advantage of dispersion that remains across asset classes, industries and ratings categories to generate excess returns. In addition, we observe that market yield and return premiums are tight for “plain vanilla” credit stories, while credits with some element of complexity may offer more attractive return potential. As spreads start to exceed their 50th percentile, the ability to just ride a wave of spread tightening becomes progressively more difficult—especially as economic and pandemic-related uncertainty persists.