Bennett says that credit is vulnerable due to a combination of high valuations where “nothing is looking particularly cheap” and the fact that “the structural problems that we have had since the start of the crisis have not been resolved” and may start to bite as the economy picks up speed.
Significant corporate credit spreads over government bonds provide a buffer against rising central bank interest rates, with high grade bonds offering more protection than investment grade ones. The excess yield on average for all corporate bonds stands at around 40% of the total yield, which is high by historical standards although roughly typical of the post-crisis period.
Bennett noted that retail investors may be poised to exit their fixed income positions in favour of equities, as the economic outlook improves, but institutional investors may take up the slack to an unknown degree. However, a turn in the economic cycle may well also spur a turn of the leverage cycle with corporations taking on debt to finance M&A activity and organic growth plans.
To reinforce his case that imbalances remain that could threaten the recovery, he noted that points where momentum has started to build at various points over the last few years have proven to be false dawns, due to the same root cause: “They are not independent events… they were all to do with structural problems that were not resolved… and a misallocation of debt” due to quantitative easing keeping rates artificially low.
Bennett noted that while quantitative easing has usefully made up for the shortfall in bank lending the new money has also fed asset price bubbles and reduced the return on investment by facilitating projects that would not otherwise have made economic sense.
He also warned that fixed income is particularly vulnerable to governments inflating away their debts, although the emergence of inflation could also produce an overreaction. “This is very difficult to generate in a calm and controlled manner with central banks likely to come under pressure to raise rates, and thus quash growth, at the first sign of inflation.”