Free cash flow production becomes even more valuable

US CREDIT MARKET SIGNALS CONFIDENCE

The bond market is once again the most stringent and influential master for US Federal Reserve (Fed) policy. After the US central bank had embarked on an unprecedented tightening path in March, credit spreads began to widen in a material way, signaling the market’s concern about the risk of a hard landing of the US economy. Between March and early July, credit spreads of BB and B rated USD corporate bonds almost doubled from 2.3% to 4.2% and from 3.7% to 6.7%, respectively. The warning did not fall on deaf ears, as the more dovish press conference of the Fed in late July indicated. The broad credit market honored the dovish pivot with a spread compression that was even faster than the preceding widening. Indeed, credit spreads of BB and B rated corporate bonds are back to 2.9% and 4.9%, respectively, matching their long-term median levels. In other words, the corporate credit market is now positioning, not for a hard landing, but rather for a return to the pre-Covid-19 trend of low growth and moderate inflation. We have maintained our risk load during the challenging second quarter, arguing for a more measured rate path than the money market had been anticipating back then, and have accordingly benefited from the recovery mentioned above. Going forward, it is prudent to harvest the current run rate of moderate credit risk of 6% to 8%, but we caution that the market has discounted a stabilisation of both demand and price pressure. Only clear evidence that inflation is ultimately slowing towards the Fed’s tar-get would be an invitation to add to positions.