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The Big Conversation

Episode 128: Are credit markets too calm?

This week Jamie McDonald talks to Indrani De, LSEG’s Head of Global Investment Research, about the outlook for credit and the economy, including the impact that higher oil prices will have on growth. Indrani highlights that the credit markets are not yet showing any signs of stress, having only reached levels that were achieved prior to the pandemic. Are they a lagging indicator or are recession fears overblown? It may be the grinding rise in oil prices that eventually become the main drag on growth, as they have been in the past.

  • Jamie Mac [00:00:00] This week OPEC Plus surprised on the upside in terms of oil supply numbers, but yet the oil price finished the day up. Seemingly nothing can stop this move. This along with the fact that the Fed started QT on June 1st, are just two of the topics that I get to discuss this week with Indrani De, who's head of Global Investment Research at LSEG. That's this week's Big Conversation.

    Jamie Mac [00:00:26] Indrani De. Welcome to The Big Conversation.

    Indrani De [00:00:28] Thanks. Very glad to be here, Jamie.

    Jamie Mac [00:00:31] Okay. So I think there's a couple of big topics to talk about this week. The first one is oil, now last week, OPEC Plus gave us some data which surprised on the upside in terms of supply. But the oil price was down momentarily, not even for a day. So what I'd love to ask you is what does the world look like if oil just keeps trucking on to $150?

    Indrani De [00:00:53] So let me step back, and add a very important thing about oil. Oil prices get impacted not just by the usual business cycle of demand and supply. There are structural things that could be changing. Oil is very impacted by geopolitics, and oil is a combination of a real asset, a commodity, and it has a lot of structure of financial instruments in it because increasingly oil gets traded so much that it's a combination of a real asset and a financial instrument. And hence it has linkages to the real economy. It has linkages to the financial markets. Now, OPEC Plus increasing the supply was obviously a good, good thing in a market where we have had so much supply shock and hence a rise in oil prices. But coming to your question of why OPEC Plus increased supply did not lead to oil price, really taking a dip, and I think a very important reason for that is what's happening in China. Now China is the world's second-largest commodity consumer, and we went through a couple of months where you had huge lockdowns because of their zero-Covid policy. So that took a lot of the oil demand out of the market. But China, I mean Beijing and Shanghai, the lockdowns are easing and things are becoming more normal. So a lot of additional demand is coming back into the market, which is well-timed with as the OPEC's supply increased, but because of that, you did not see the extent of reduction in oil prices that you might have seen otherwise. And the other thing to remember is because the world is so scared of this oil price increase, a lot of the transition to the green economy, which was already planned, it's actually picking up steam even more. So that structural change is happening faster. Just to give you some simple numbers, like electric vehicles, the demand, the number of electric vehicles, it's almost tripled in the last two years. China wants to make one-third of its electricity from renewables by 2025. So the market is kind of changing because of that, too.

    Jamie Mac [00:02:54] Okay. So that does help with the question of why oil keeps ticking up. But when I switch on the TV and I look at people, particularly in the equity market, if we talk about how that oil price can impact other asset classes, a lot of equity bulls out there are not saying that inflation is going away, but that inflation expectations have peaked. So if oil is going to continue trucking on, as it seems to be, how is it that, you know, inflation expectations can have peaked if what happened last week continues to happen?

    Indrani De [00:03:29] That's an excellent question. I think there is some kind of a natural ceiling beyond which oil prices cannot go up because demand destruction really kicks in. Even if you go back long periods in time, couple of decades, that ceiling seems to be about $140. So anytime it reaches in that $125, $140, the demand destruction sets in. Now, oil in the immediate short run, the demand is fairly inelastic, but, you know, give it a little more time, and the destruction sets in. People look for substitutes. Growth slows down because, you know, if inflation picks up financial, the central banks really do their best to slow the inflation even if growth slows, which is where we are right now. And that, I think, is a very important reason why inflation expectations seem to have peaked in May. Like we tracked the data by seeing the FTSE World Government Bond indices and the inflation linked version of the same. So by comparing the two, when you see the breakevens across all durations, whether it's 1 to 3 years, 7 to 10, and the really long run 20 plus, we see that those inflation expectations came down in May. And part of the reason is because central banks are so set that they will control inflation. So growth will go down, the demand destruction will happen and that's why we are seeing the inflation expectations having peaked.

    Jamie Mac [00:05:01] I do often hear that the cure for high prices is high prices. They will be self self-destructive on the demand side. You speak about central banks and that's one of the other things I wanted to talk to you about. Last week, June 1st was the first day the Fed begins QT and I wondered if you could talk a little bit about how you think the mechanics of that will work and what will be the impact on credit markets?

    Indrani De [00:05:24] That's an excellent question because when QE, the quantitative easing happened pretty much after the last financial crisis, it was called unconventional monetary policy. You know, central banks directly stepping into the corporate bonds and the credit markets. Now, we have seen enough quantitative easing over the last 10, 12 plus years, the reverse of it, the quantitative tightening is something really new. So to that extent, there is more unknown about it. We know what happens when central banks increase the rates. What happens when they do the quantitative tightening? It's in reverse. That is a little more unknown. Having said that, we have to see what's happening in the credit markets like right now. See financial markets are forward looking. So markets knew that the Fed is going to be rolling off its balance sheet starting June as it happens. ECB has announced that they are going to stop their asset purchases in a couple of months time. So that expectation is baked into the market. So what we have seen in the credit markets, and let me touch upon the high yield, because high yield is really known as the canary in the gold mine. So credit markets are showing that high yield spreads have increased, but they have still increased only to what it was in the pre-Covid era of 2018 or 19.

    Jamie Mac [00:06:44] In both Europe and the US?

    Indrani De [00:06:46] Pretty much, pretty much in both the Europe and US. So they are nowhere close to the COVID shock of 2020. They are not even close to what it was during the 2015, 2016, you know, when there was the China slowdown crisis. So high yield spreads have increased, but they are just at pre-COVID levels. So you really don't see that extreme level of stress in the high yield market till now. And let me touch upon, since you've talked about high yield, high yield is really like a risky asset, and that is why it has a very high correlation with the equities. We looked at the last three years correlation between the FTSE US High Yield and the Russell 1000 equities, and the correlation is something like 80%. So when we are talking about credit spreads, we are really talking about what happens in all risky assets. So so far, markets have really not shown that extreme level of stress.

    Jamie Mac [00:07:42] So just focussing once again on the credit markets, do you feel that there's going to be more attention going into high yield credit as a more attractive asset class to be in right now?

    Indrani De [00:07:51] Certainly, there is still a search for yield going on because while rates did go up, but we saw that the 10-year Treasury stayed above 3% for a little while and now it's back down to about 2.9 percentage points. And particularly if inflation gets under control, pension funds, they have huge liabilities. So the search for yield will still continue. So that still will mean money will go into higher yielding, risky assets. And they should as long as we don't have a huge liquidity shock or dislocations in the market. If markets function normally, then they give you higher returns and they remain attractive to people looking for yields.

    Jamie Mac [00:08:35] Yeah. So maybe the last thing we can talk about, we've as you say, we spent the last several years being in a quantitative easing environment, but we've also been in a period maybe much longer than that of globalisation and we're now entering this period of de-globalisation. And de-globalisation, by its very nature, seems inflationary. I was wondering if you had any views about where we are along the sort of de-globalisation journey and if it set to continue, what kind of pressures that has on assets?

    Indrani De [00:09:06] So two things actually, that's a very interesting point and I know most people are talking about de-globalisation now because the world is kind of breaking into blocks. We almost seem to be going back to a Cold War era in a new version. But I would point out actually globalisation peaked just around the financial crisis of the last financial crisis. Global trade as a percentage of global GDP has actually been slightly decreasing since then. However, the current crisis is obviously when it really kind of hits us in the face that we are seeing more de-globalisation. I think what really matters is the efficiency increase that we saw from globalisation, just in time supply chains, it led to a lot of efficiency increases. That efficiency will kind of go down, which could mean profits going down, slowing growth. I think that's where we will see a lot of change going forward.

    Jamie Mac [00:10:03] And Indrani, I know you're the Head of Investment Research globally, so I wondered if you could just sort of summarise a little bit between the three main geographies, sort of Asia and Europe and the US, kind of how you see markets panning out this year?

    Indrani De [00:10:17] You know, one of the most interesting trends that I'm seeing right now is we have divergence in central bank policies right now. US and ECB, US, UK, ECB, they are all in different phases of tightening. UK and the US furthest ahead. ECB Now getting into the tightening, but we have a different set of policies in Japan and China, but it's still a continuation of those policies or China is still easing a little bit in its mortgage markets and things like that. So I think that has major implications of how money flows across the world capital flows. And one interesting thing that you will see is traditionally whenever the Fed raises rates, emerging markets, money starts flowing out of them, or it leads to big emerging market spreads increasing. This time around, we still haven't seen that big panic in emerging market debt or that spreads ballooning up too much. And part of the reason is see what is happening with oil, commodities, agricultural commodities, because we need them so much more. The commodity exporting countries are doing very well. A lot of them are emerging market countries, which is why you see the Brazilian real is one of the best-performing currencies. So I think the world is a little different than a standard cycle where you would expect EM to really you know...

    Jamie Mac [00:11:41] Yeah, it's very interesting to see these commodities being so strong, and and equities and bonds being so weak and supporting those emerging countries, that it's it's tough to but it seems like a very tough moment to be investing generally right now.

    Indrani De [00:11:54] I think we have reached a point that there was a time when everything kind of was going up. So one didn't need to be a very selective investor because you were getting good returns in every asset class or maybe most geographies and things like that. Right now, the dispersion in returns is increasing. So you've got to be more selective where you're putting in your money and that applies across asset classes and applies in different geographies. Like just to give you a simple example, for so long, over the last 10, 15 years, US equities were the clear outperformer. We have seen that trend reverse simply because the growth value has reversed. Now it's value is doing better and hence the US has gone from being an outperformer in the equity markets to so far year today being an underperformer. So you're seeing changes happening, you're seeing differences in returns. And that's why it's a, it's a very interesting time to be an investor because if you make the right choices, you can see good results.

    Jamie Mac [00:12:53] Time to be selective then?

    Indrani De [00:12:54] Time to be selective. Absolutely.

    Jamie Mac [00:12:55] Indrani, thank you so much for your time. We've really enjoyed chatting to you.

    Indrani De [00:12:58] Likewise, thank you so much.