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Why the Market's Fears Over Credit May Be Overblown

Kenneth A. Orchard, Portfolio Manager

Markets have begun the year in a jittery mood. Credit spreads have widened alongside falling stock prices as concerns over a U.S. recession have spooked investors still twitchy from last year’s volatility. But while a recession in the near term cannot be ruled out, I don’t think one is likely to occur in the immediate future— and, as such, I believe that credit is probably a safer investment than many others seem to think.

As recessions tend to cause higher default rates, the primary determinant of credit spreads is the economic cycle. Predicting the timing of a recession is notoriously difficult, though, and this time is no different. On the one hand, the U.S. economic cycle is clearly at a late stage: Corporate earnings are peaking, U.S. monetary policy has tightened, and economic growth is slowing. On the other hand, some classic leading recession signals—such as an inverted yield curve—have yet to materialize (although the yield curve does appear close to inverting). In addition, T. Rowe Price’s own models suggest that there is a low probability of a U.S. recession within the next year, albeit with a higher cumulative probability of recession within the next two to three years.

Wider credit spreads are themselves a traditional signal of recession. Historically, these have tended to occur in two to three waves: The first period of spread widening typically comes six to nine months before a recession, the second usually arrives three to six months before the recession, and the third during the recession. Focusing on U.S. investment grade, spreads widened 40 basis points between February and July and another 50 basis points between September and year-end. If we take last February’s spread widening as the typical starting point, we would expect a recession to begin within the next three months; if we begin from September’s spread widening, we would expect the recession to begin around the end of 2019.

Opening Quote Based on all the available evidence, a recession seems extremely unlikely in the next three months, while a recession in 11 to 12 months is plausible. Closing Quote

Based on all the available evidence, a recession seems extremely unlikely in the next three months, while a recession in 11 to 12 months is plausible. In either case, spreads can be expected to move sideways or even tighten slightly for the first six months of this year before possibly widening after that (if a yearend recession materializes). Anticipating this, we increased our credit exposure in global multi-sector and diversified income strategies—primarily through liquid and shorter-dated instruments—in the back half of December 2018. Our credit risk exposure is now the longest it has been in over 12 months and approximately at the midpoint of our historical exposure range.

I certainly do not want to be too long credit in the current environment—the market isn’t cheap, and the global economy faces a number of risks. Overall, however, I think that the probability of a recession in the near term is less than the markets believe; therefore, it makes sense to raise credit exposure for now while we continue to evaluate the data as it emerges.

Key Risks—The following risks are materially relevant to the strategy:
Transactions in securities of foreign currencies may be subject to fluctuations of exchange rates which may affect the value of an investment. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default which may affect the value of an investment. Investments in High Yield involve a higher element of risk.

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This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products
and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

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