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There is a lot happening in the global economy right now, but if we were to choose one piece of data that is likely to inform our thinking about credit markets over the next six to 12 months, it would be the reduction we’re witnessing in the global central bank balance sheet (Figure 1).
There was, of course, a huge spike in central bank asset purchases in 2020, in response to the pandemic. But more broadly, we have seen nearly $20 trillion of central bank purchases since the global financial crisis (GFC) in 2008. From a market perspective, we’ve been quite spoiled. Even when central banks made a concerted effort to take back some stimulus in 2018 – 2019, they pivoted away from that path fairly quickly when markets started to crack.
What's changed today and left central banks willing to begin withdrawing liquidity? There is now a clear trade-off between growth and inflation that didn’t exist prior to this year. Inflation has reached levels we haven’t seen since the 1980s, creating a cost that central banks cannot ignore.
Our research suggests this change is structural, and that we should expect more cycles and much greater volatility in economic growth and inflation. In our view, central banks are no longer a suppresser of volatility, as they generally have been since the GFC. Instead, they are more likely to amplify volatility going forward.
There has been a clear link between global quantitative easing and the direction of risk assets, including equities and credit spreads. This will likely present a challenge for investors for the rest of this year and into 2023. We think central banks are behind the curve and have a long way to go in reducing their balance sheet. In fact, they still completed $100 million in asset purchases in the first few months of this year (following $3.5 trillion in purchases in 2021 and $6 trillion in 2020). But by the second half of 2022, central banks will have fully transitioned to being sellers of bonds.
We expect this environment to generate new opportunities. Historically, when central banks are in full tightening mode, that’s when the tide goes out and it becomes possible to see which assets were mispriced, which business models didn’t really work, and who made the wrong call by putting leverage on certain business models. This should result in heightened dispersion in the market, and in fact, we’re already seeing signs of this, as shown in Figure 2.
As credit market investors, we believe this will be a promising backdrop for exploiting inefficiencies through security selection. We think it will require a combination of top-down credit market analysis and bottom-up research on sectors and individual issuers.
For more on the macro factors driving fixed income and other markets, see our Mid-2022 Investment Outlook.