See previous 2021 prediction
The Covid-19 pandemic viciously accelerated the dangerous levering up of the global economy that unfolded during the 2008-09 financial crisis. Central banks printed ever more money and took policy rates close to the zero bound in all developed economies. The policy of near infinite liquidity provision and easing financial conditions at all costs has pushed global sovereign and investment-grade corporate yields to historical lows and forced investors to take positions in riskier assets.
As 2021 gets under way, the merciless march of lower yields has left yield-seeking investors sitting on a pile of low-yielding junk debt with terrible reward-to-risk profiles, as zombie corporates teeter on the brink of default, having only survived the pandemic months with handouts and the lower refinancing costs. The investors’ risky stance is justified by the prospect of an effective vaccine bringing a new boom in economic growth. But reality doesn’t prove so kind, as the vaccine roll-out and the removal of Covid-19 restrictions and normalisation leads to a sharp spike in inflation. In perfect hindsight it turns out the economy was vastly over-stimulated during the pandemic, and the ripping post-vaccine recovery rapidly overheats the economy. Inflation rises and unemployment falls so rapidly that the Fed allows long treasury yields to spike higher, taking the yield on riskier debt with it.
The Fed ends up making a policy mistake by allowing financial conditions to tighten too rapidly via higher longer rates, having never implemented yield curve control as they were too distracted by the sudden spectre of 4-5% annualised inflation and 6-8% annualised wage gains by Q3. Corporate defaults rise to their highest in years, with the first to go the most over-levered companies in the physical retail space that were already struggling in the solid, pre-Covid economy. For the first time in economic history, a strong recovery sees rising defaults.
Trade: Short HYG and JNK High Yield corporate ETFs
See next 2021 prediction:
Sun shines on silver, which sizzles on solar panel demand