Credit markets are way underpricing recession risk, UBS says

US corporate credit spreads were not adequately priced for Federal Reserve chair Jerome Powell’s hawkish comments at Jackson Hole, and are significantly underpricing the risk of a recession, according to UBS Group strategists.

Current credit spread levels imply a 25 per cent chance of a recession, compared to UBS’s forecast of a 55 per cent chance, strategists led by Matthew Mish wrote on Tuesday (Aug 30).

UBS expects US corporate credit spreads to retest this year’s wide levels “on further Fed hikes and slowing growth”.

The spread on Bloomberg’s benchmark investment-grade index sits at 138 basis points as of Monday, compared to a Jul 5 wide of 160. The high-yield index is at 461 basis points versus 583 on Jul 5.

“Remain cautious on credit,” Mish wrote. “With labour markets too strong and inflation too high, tightening needs to persist with risks to growth and vol now greater to the downside and upside, respectively, implying a widening bias for spreads.”

The bank is bearish on leveraged loans, in particular, and second-quarter earnings results solidified that view, Mish wrote, adding that the resilience in credit metrics for higher rated leveraged loan issuers is masking weakness in the rest of the market. BLOOMBERG